I'm hoping you have figured this out by now, but in case others are having the same problem there is a section in the livecycle designer 8 regarding how to do this. You can search for "XML schema binding" and an example schema on how to include the image data in the XML you are passing to the PDF (I've been using the XPAAJ library as well) is shown.
Essentially you just need to base64 encode the image data and include a contentType (image/jpg, image/png, etc.) and a transferEncoding (base64) attribute on the element containing the data.