There is no built in classes for doing pixel based imagine manipulation/generation i n Silverlight. You need to implement your own PNG Encoder/Decoder that works on an byte array containing the image information. Joe Stegman has implemented one such encoder you should check out. He got lots of great information about "editable images" in Silverlight over at http://blogs.msdn.com/jstegman/. He does things like applying filters to images, generating mandlebrots and more.
This blog discuss a JPEG Silverilght Encoder (FJCore) you can use to resize and recompress photos client size: http://fluxcapacity.net/2008/07/14/fjcore-to-the-rescue/
Another tool is "Fluxify" which lets you resize and upload photos using Silverilght 2. Can be found over at http://fluxtools.net/
So yes, client side image processing can definitely be done in Silverilght 2. Happy hacking!