Data: URIs
This issue was partially fixed in Internet Explorer 8 beta 1. Data: URIs are supported, but only for things like images and stylesheets, not pages. They are also restricted to just 32 KB.
These are a relatively recent development. But that does not mean that IE has not had the time to implement it. All the other major browsers have implemented it. But the IE 7 release concentrated on user interface, and security fixes and ignored the lack of standards support. The Data: URI standard was actually made in 1998 (before the release of IE5).
So what is a data URI already? It is a way of holding an embedded object in the current page. So embedded pages, images plugin data, etc. can all be embedded into the page, without needing to reference external files. The same can be done with images in stylesheets. This may seem unnecessary, but it can prove very useful when you want to make a completely self contained page, that you can pass to other people. You give them just one HTML file. They do not need to unpackage anything. They just open the file in their browser, and all the images and embedded objects it references are immediately displayed. They do not even need a connection to the Internet.
It also makes page maintenance much more easy. Say you are restructuring your site. You move files from one directory to another. Suddenly everything breaks because the image references are no longer pointing to the right place, and you forgot that you had to change the third image tag that points to the image in two directories up, one across and down three levels. So you have to find every occurence of the image tags, and rewrite them. With Data: URIs, the page with images would be completely self contained. To move the page, you just move the page, and the images move with it. Simple.
Ok, so I know that it means that even with images disabled, they still have to be downloaded, and I know that you may not need to do this all the time. But for the times that this would be useful, wouldn't it be nice if IE actually allowed you to do it like the other browsers do?
Demo: You should see an image here:
Workaround: Use regular images and web page references. Put in the extra time and money to manage restructuring. Teach people how to open archive files for packaging, or hope they don't mess up your folder structure.