There are a couple of ways.
If you use the img tag method, you supply a URL for the image between the tags, not the image itself. The full-size image will be visible inline when the post is viewed.
To use the attachment method, you need to open the "Attachments and other options" panel by clicking on the title, and then clicking the "Choose file" button. The image will be uploaded to LuLa when you post. A thumbnail will appear under the text of the post; clicking will expand it, either inline or in a new window depending on its size (if there are more than about 1200 pixels on the long edge, it will open in a new window). There are restrictions on the maximum size of the file.
If you use the second method, preview doesn't show the thumbnail (it can't; it doesn't yet exist). I'm not sure about the first.
Jeremy