The best way is to open the image in Photoshop, erase the background, save as a layered PSD file and Place in AI, checking the box for maintaining the PSD layers on import. This should give you the transparent, outlined image that you want. Or in AI, draw a path around the image as you want and then select the image and the path and from the Object menu, Object>Clipping Mask>Make.
Thank you very much for your help. I managed to get what I wanted. I did have to make sure that there was more than one layer in the .psd file otherwise it automatically created a white background with the image in one layer.
Haven't tried making the path and clipping mask yet...
You did not have to have two layers you needed the one layer to be a real layer and not a background layer that is all the is required as was already posted.
If you have the background layer in photoshop that is a flatten file and that has no transparency.
if it is transparent then a tiff or psd file works in CS4. This is the file in Photoshop as a transparent layer;
This is the image place in Ai over a colored filled rectangle path.
It could not be simpler.
I hope this helps you simplify your work. Thinking smple is often the best way when going from PS to AI I always found.