The Hero lets you crop your image before it sets it as the wallpaper, resizing it automatically. Just try setting one of the stock photos it came with as a wallpaper, and you'll see how it works.
As for what resolution it uses natively? 640x480 sounds right to me. The Hero's screen is 480x320, and with the way the background slides as you scroll sideways, that 640 pixels wide makes sense.