Finally, Google has added support for adding inline images while composing an email similar to MS Outlook. For inserting images, you have to enable this feature ‘Inserting images’ from Settings->Labs menu as below.
Once you enable this feature under (Settings->) Labs tab, you will see following option (squared in Red color in below image) on toolbar while composing an email.
Below is dialog box (popup) opened when you click on insert image option above….
And after inserting an image it should look like this,
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