I got pictures working!
It seems that Word 2007 outputs webpages in a strange way, which doesn't seem to work well with images. I changed a few Word settings and it now outputs an HTML file that contains the pictures, which Calibre then converts to a perfect LRF file!
I changed the settings to this (all were selected, and I don't know which one fixed the issue, but everything else still works) This is under Web Options:
http://cid-b7a2d2defc887e52.skydrive...tmloptions.JPG