When saving a new premium and selecting "Use default image" - an invalid url is saved to civicrm_product.image and thumbnail. Looks like an extraneous string composed of the "http//serverName" is being injected in the URL. You can recreate this on the 1.7 sandbox by adding a new premium under Manage Premiums. The resulting value in the DB is:
Please check the logic for setting image and thumbnail value for other cases as well (uploaded file, and display from web locations).