In addition to embedding images in the HTML file (which, as you discuss, is not a great choice) TiddlyWiki allows linking external images. In particular, you can use relative paths to link to image files on the same drive as the TiddlyWiki. I use this functionality a lot. It has the disadvantage that your Wiki is no longer a standalone HTML file, but it's still a standalone folder, which is often good enough.
In addition to embedding images in the HTML file (which, as you discuss, is not a great choice) TiddlyWiki allows linking external images. In particular, you can use relative paths to link to image files on the same drive as the TiddlyWiki. I use this functionality a lot. It has the disadvantage that your Wiki is no longer a standalone HTML file, but it's still a standalone folder, which is often good enough.