Resource files such as images and xml data files need to placed somewhere and referred to by  the app.  They can be in two places:
-Isolated Storage.
-ApplicationStorage.

IsolatedStorage is located (someshere) on the device. Items there can be stored as per app, per user, per system(??)

Application Storage is those files that are somewhere in teh application's build tree that have been tagged to be included in the build as resources.

Application data is readonly whereas Isolation data can be changed.

Application data is either Resource files are Content Files. References are either Absolute wrt the application tree or relative (you do have an OR option for these as well).

Some typical references to a application resource is:

(i) An application resource
B1.Source = new BitmapImage( new Uri(@"/FootyWhatIf;resource/Images/background.png", UriKind.RelativeOrAbsolute));

Note that the application name is included (FootyWhatIf),
it is tagged as a component. This requires that the file be configured as a Resource in its Build Action property).

(ii) An application resource
B1.Source = new BitmapImage( new Uri(@"/FootyWhatIf;component/Images/background.png", UriKind.RelativeOrAbsolute));

it is tagged as a component. This also requires that the file be configured as a Resource in its properties).

Programmatically, resource files are access using Application.GetResourceStream, as when loading XML.

 

References:
http://create.msdn.com/en-US/education/quickstarts/Getting_Data_into_your_Windows_Phone_Applications