It's only 5 megapixels, but during iPhone 4's launch, Steve Jobs specifically noted that when it comes to image quality it's not all about how many pixels you have. The backside-illuminated (BSI) camera sensor with large pixel sizes allows it to deliver excellent image quality under normal lighting conditions.
There's no optical zoom on the iPhone 4 and the size of the image sensor is smaller than the tiny ones used in compacts, but this new camera is approaching point-and-shoot quality, and may drive some people to ditch their pocket cameras and look to the newest iPhone for everyday snapshots.
After spending a few hours walking around San Francisco, I'm pretty pleased with the images. Under optimal bright lighting, it's outstanding and even in low light, you can see how the backlit sensor helps by sending more light into the sensor. The blacks look very good, avoiding the common grain, noise, and discoloration common in point-and-shoot cameras from just a few years ago.
Take a look at some of my test shots from the streets of San Francisco with the iPhone 4. (These images were opened in Lightroom to crop and straighten, but no sharpening or color correction was performed.)