It appears as thought either the previous implementation of inline image copy/paste was working because of a bug or the update introduced a new bug. So what is the issue?
Updating my workstation with the March 2014 patch (http://support.microsoft.com/kb/2863908) my client shows this version now:
When a user attempts to copy/paste a picture inline to the IM window you get this message:
Prior to this patch, the copy/paste of images to the inline conversation window worked fine. My immediate thought was, this requires file transfer so what happens if I enable Peer-to-Peer File Transfer in the conference policy.
Once I enabled the policy and logged out and back into my client, I was able to inline image again.
So there you have it. If you update to the March 2013 and need to use inline images, make sure to enable peer-to-peer file transfers in your conference policy.