It's a universal truth that cameraphones are terrible cameras. The idea is a great one, but with such poor quality it's no wonder most people don't even bother. They are so bad they are almost worse than no camera at all.
However, cameras in phones are getting better, though they still don't come close to rivaling stand-alone digital cameras, and they are convenient since often you find yourself in situations where your phone is the only camera you have.
The camera in the iPhone is better than many though it's got a lot of limitations, but if you follow a few techniques I'll explain you can actually take some surprisingly good photos with it.
First, forget the idea that resolution has any bearing on picture quality. It is a camera's lens and electronics that make for good pictures: resolution is only a factor for enlargements. The iPhone's two megapixel resolution means it's okay for small prints (4x6 maximum), but it's fine for email and website work. If you can coax a decent picture out of the camera, that is.
Unfortunately, like most cameraphones, the iPhone's camera lens is poor, offering fixed-focus and no optical zoom, a sluggish shutter, and no image stablization, making blurry images common. There's no built-in flash, either, and the iPhone's camera software is minimalist, offering only a single "take photo" button and no way to adjust settings of any kind.
Interestingly, the iPhone's pictures look even worse simply because it's such a great multi-media device. When you're browsing your photo library on your iPhone and see your iPhone photos mixed in with the much better quality pictures from your regular digital camera, the contrast is not flattering for the iPhone's camera.
Basically, if you have access to any standalone camera -- even a disposable film camera -- use that before the iPhone's camera (or any cameraphone for that matter).
But in a pinch, all is not doom: with adequate lighting, a steady hand, an appropriate subject, and some composing techniques, you can take surprisingly good pictures with the iPhone.
"Fixing" Bad Photos with Photoshop
A quick aside about software retouching: if you think you can fix bad iPhone photos in software such as Photoshop, think again. The problem with low-end cameras such as cameraphones is that the errors run deep and integral to the image. The time it takes to "fix" such photos are considerable, and they still look like crap. So I generally wouldn't bother. You're a thousand times better off taking a good picture to start with, and then if you want to tweak it slightly later, you might even end up with a great photo. But the best you can hope for with a bad photo is making it mediocre.
Get the Light Right
The first thing to consider with any iPhone photo is lighting. The iPhone needs plenty of light but not too much. Photos in dim lighting are useless. But too much light will blow out the highlights and create overly strong contrasts and washed out faces. What you want is neutral lighting: a bright but overcast day for outdoors, or even, well-distributed light inside without glare. Try to find reflective light instead of direct light, as it will be less harsh and more natural.
Be careful about backlighting: never take a photo of someone in front of a window. Not only is the window distracting, but the incoming light will confuse the camera's sensors, causing improper exposure and resulting in an overly dark face:

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I've found the iPhone to be extremely sensitive regarding lighting. The camera adjusts constantly and if you change the camera angle or your position even slightly, you'll often get a completely different exposure. This is both good and bad. It's bad because it can change without warning just before you press the shutter, but it can be good because often you can improve a bad photo by just adjusting the camera's angle a few millimeters.
Here's an example where I've still got a window in the background (the composure is admitedly poor), but at least I got the lighting right this time:

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Choose an Appropriate Subject
The nature of the iPhone's fixed lens camera is that it is terrible for distance shots. Landscape shots look like they were captured off an old VHS tape. There's just no detail and without a zoom you cannot see anything in the distance. The iPhone doesn't have a macro lens, either, so it's not too sharp for close-ups.
Here are some example landscape shots. Note that these don't look too bad when reduced in size, but if you look at the 100% size, you'll see there's tons of noise in the treeline and water of the first picture.

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In general, I'd only use the iPhone's camera for general purpose shots of objects and people within the two to twelve foot range. The lens seems optimized for things at this distance and while you can get to work at other distances, it's generally not worth the effort. The iPhone works best for shots of people: faces come out crisp and clean and the coloring is pleasing.
This is a photo I took of my uncle at a restaurant and I was extremely impressed with the clarity and crispness:

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This is a "still life" shot of some fresh tomatoes. As you can see, not terrible, though the tomatoes themselves are rather blurry (we'll call it "soft focus" and pretend it's intentional
:

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Don't Move
Because the iPhone has such a slow shutter, movement of any kind -- either by you holding the camera or by the subject -- results in blur. Even slight movement contributes, so while you might think the picture wasn't too bad, once you zoom in you'll see that the details are fuzzy.
Just keep this mind: don't use the iPhone for candids, but ask people to pose (tell them you want to add their photo to your contact list and even the photo-shy will be flattered enough to comply) and tell them to stay very still. Brace yourself: stand with both feet flat and hold the iPhone with two hands and your elbows in to minimize body movement. If you can, prop your elbows on a table or chair back (or fence or tree if you're outside) or lean against a wall. It may not seem like much, but trust me, it definitely helps.
Notice in this photo how the woman's moving hand is blurry with visible jaggies:

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The rest of the photo is sharp and looks good, but the iPhone just can't capture movement at all. (You might also notice how the sunlight on the chairback washes everything out and loses all detail: it's too bright and even the bushes behind the chair are poorly captured.)
Get an Appropriate Background
With most cameras there's a flash to illuminate the main subject or the camera auto-focuses and the background comes out slightly blurred. Either of these techniques help the subject stand out. But with the iPhone, you don't have those luxeries, so you need to think ahead and plan. Don't just snap someone's picture wherever they happen to be: find an appropriate background.
Look for a neutral background with texture. A bare white wall is boring and reflects too much light and can create distracting shadows. Cloth or wood or nature make excellent backgrounds as they are soft and naturally fuzzy and if the colors are muted they won't overpower the subject. You want enough contrast that the subject stands out (a brown puppy on brown carpet is not good), but you don't want distractions.
Remember that a centered portrait isn't interesting and looks too posed, like a DMV photo. Find something interesting in the background and photograph the person next to it, so it looks like they are both part of the picture. For instance, a person leaning against a marble column gives you two vertical lines and is more intriguing than a mug shot of the person in front of the column.
Standard portrait techniques apply: watch for poles or objects coming out of people's heads, glare off glasses, etc.
Fill the Frame
The iPhone's lens is fairly wide. This can mean you'll often capture more background than you need. Don't be afraid to step up closer to your subject and fill the frame.
Here you can't even see the cat in the center of the photo!

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Use an Unusual Angle
All pictures are more interesting when taken from an unusual perspective, but the iPhone camera's limitations make that even more important.
Here's a shot of my cat, Mayhem, from a boring above perspective:

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See how you tend to notice the poor picture quality? That's because it's just not an interesting picture.
I took this a moment later, getting down to his view, and it's much more dramatic:

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You can see that the background is blurry and full of noise, but that hardly matters because the main view is so much more intriguing.
Be Patient
Don't be in a hurry. Unlike a regular camera which is more forgiving and gives you more controls, a cameraphone requires more effort for a good photo. Don't rush yourself or your subjects. Just take your time, watch the iPhone's huge LCD, and don't be afraid to experiment. If you take a bad photo, delete it and try again. Don't be satisfied with a poor shot. Keep trying until you get something decent.
You Can Crop
A nice feature of the iPhone is that it allows you to crop photos used for contacts. When you assign a photo to a contact, you can zoom in and reposition the photo (using pinch/strech finger gestures). This is helpful as you can assign the same group photo to different contacts, for instance, by zooming in on individuals.
Use the Self-Portrait Mirror
iPhone has been criticized because there's no self-portrait mirror. There's also no timer for taking delayed pictures, though that's something Apple could certainly fix via a software update. So how do you take a picture of yourself?
Use the Apple logo! If you look on the back of the iPhone the Apple logo is shiny, reflective metal. It works like a mirror. No, you can't see everything that the shutter's seeing, but you can see enough of yourself -- a nose or eye or chin -- to figure out where you should be holding the phone for a good self-portrait. It may take a few practice shots to figure out what works best, but it the mirrored logo is definitely helpful.

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See? Except that it's me in the photo, it's a decent self-portrait.
Find the Shutter Release First
While the iPhone's touch-sceen is awesome as a software interface, it does not make the best camera shutter release. The "take photo" button is flat and not a big button, making it too easy to move the camera while trying to take the picture. (Hopefully eventually Apple will add the ability to use one of the hardware buttons on the iPhone, such as the volume rocker, to act as a shutter release. That would be much more natural for taking pictures.)
My solution is to position my finger over the button first, then adjust the camera angle and compose the shot. That way when I've got the shot I want, a tiny bit of pressure from my finger takes the shot without me moving the camera or looking away from the photo. Something this means I inadvertantly take a picture by tapping the button accidentally, but that's a small price to pay for better pictures. It's not like it's a waste of film!
Take Tons of Photos
Speaking of film, the iPhone is a digital camera, so don't be shy about taking pictures. Take tons. The photos you take are stored on the iPhone's 4GB or 8GB of internal memory. Each is less than three hundred KB in size, so leave yourself at least a few dozen megabytes free and you'll have room for a hundred pictures or so. Take lots of pictures. Not only will the practice help you learn to be a better photographer, but even professional photographers know that a handful of quality shots out of a whole roll of film is a good ratio. You can always delete the ones you don't like.
Get Inspiration from Others
Finally, check out what other people are doing with their iPhone cameras. Some of the pics aren't too bad!
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