Just stumbled across something you may find helpful!
Whilst exporting my project earlier today, I neglected to uncheck the minify option. After base64 encoding my c2runtime.js, the file size came out at approx 7mb. When I tried to run the project on my device, all I got was a black screen. Needless to say, I did start to hyperventilate a little at this point ;)
Upon realising my mistake, I re-exported the project (with minify unchecked). This time, after base encoding my images, my file came out at approx 4.5mb, and the project ran really well on my device.
Hope this information helps to shed further light on packaging apps for Windows Phone!
**Edit** - In my first attempt, I did also try updating the WMAppManifest.xml in the way you described above. Although I still just got a black screen when running it on my device.
<img src="smileys/smiley1.gif" border="0" align="middle" />