I have a JPEG image defined for 8.5" x 11" paper. The JPEG itself prints fine - the image stays within the margin constraints, etc... However, when I use this same JPEG as a background-image in my XSL, the output shows the background image being blown up/enlarged. Only the upper left hand portion of the image displays on the final output.

What FO processor are you using?
The size of external graphics can't be controlled the same
way the size of external-graphics can be controlled. You
are stuck with the (usually fixed) resolution the processor
chooses for teh background image. The spec does not mandate
any specific behaviour with respect to chhsing the resolution
of bitmap background images.