Why can't I do <img src="C:/localfile.jpg">?

It would be a security vulnerability if the client could request local file system files and then use JavaScript to figure out what's in them.

The only way around this is to build an extension in a browser. Firefox extensions and IE extensions can access local resources. Chrome is much more restrictive.

shouldn't you use "file://C:/localfile.jpg" instead of "C:/localfile.jpg"?

Browsers aren't allowed to access the local file system unless you're accessing a local html page. You have to upload the image somewhere. If it's in the same directory as the html file, then you can use <img src="localfile.jpg"/>