You didn't do things wrong. This is apprently a bug in the 9.3.x software where the default properties of the image service published in 10 can not be read by 9.3.x clients. However, these compressions are available for you to choose when accessing the image service. So the workaround is to set the compression and resampling method from the 9.3.x client. For example, from ArcMap, open the image service layer propertie page->display tab, you can set JPEG compression and Bilinear resampling method, the image request to the server will be using the properties you set.
Hong Xu
Raster team, Esri.