Images displayed by Java applets are retrieved from the web via a URL that points to the image file. An applet that displays a picture must have a URL to the image its going to display. Images can be stored on a web server, a local hard drive or anywhere else the applet can point to via a URL. Make sure you put your images somewhere the person viewing the applet can access them. A file URL that points to your local hard drive may work while you're developing an applet, but it won't be of much use to someone who comes in over the web.
Typically you put images in the same directory as either the
applet or the HTML file. Though it doesn't absolutely have to be in
one of these two locations, storing it there will probably be more
convenient. Put the image with the applet .class file if the image
will be used for all instances of the applet. Put the applet with
the HTML file if different instances of the applet will use
different images. A third alternative is to put all the images in a
common location and use PARAM tags in the HTML file to tell Java where
the images are.