Firedog,
I think you are misunderstanding the issue.
From OP:
I have "Block images and other external content in HTML email" checked in the Safety Options on the Security tab. It works exactly the way it should so I get an email with images and they're blocked unless I click "Show images" on the message or if they are already in my Safe Senders list.
However, this works for all my accounts in Live Mail except my Hotmail account. For some reason ALL images just show up and are not blocked.
----------------- (emphasis mine)
This has nothing to do with the "Security Level". The setting is "Block images and other external content in HTML email" This should apply to ALL e-mail, whether its spam, Nigerian Princes, a message from my GF, MSN, or Amazon. But, alas, HTML e-mails from everyone in my Inbox automatically show the images without prompting. The headers, the footers, and (presumably) the "blank" gifs they use to track when you've opened the e-mail. We don't want that. (Correct me if I'm wrong, Jim)
And it works as expected/intended for all other accounts setup in Live Mail (GMail) (ie. images don't show up at all until clicked on appropriate link).