The XZ-1 recorded a maximum result of 1800 x 2000 LPH on our resolution chart, which means it's capable of recording high levels of detail. It's hampered however, by what looks like aggressive noise reduction, which results in smudging, moiré patterns and general loss of detail in JPEGs. We also found that the Natural color mode tends to saturate the warmer colors, making skin tones a little orangey in some instances. All of this is nothing that shooting in RAW won't solve, and here the XZ-1 can shoot an impressive 11 to 12 frames successively before the buffer runs out. But RAW is a work flow which not every consumer compact camera user will understand.
So if you're shooting in JPEG, you need to keep within the lower ISO settings, not because image noise is the issue but because noise reduction smudges more detail as sensitivity goes up. ISO 800 is when some noise starts to appear, but if you're not pixel-peeping you might be hard-pressed to see much image noise until ISO 1600 and above. Needless to say, this is much better than you can get from a typical compact camera.
The fast lens helps you to keep your ISO down and thus get less noise in your shots; in fact, while shooting at night, the XZ-1's wide aperture helped us get steadier shots with faster shutter speeds and lower ISO settings than most compact cameras can muster. The downside to this is that at f/1.8 your focal plane is pretty tight, and anything too far back (like a friend standing behind your other friends) runs the danger of becoming part of the background blur.
In our experience, the issue is further compounded in iAuto mode, where the XZ-1 prefers to shoot at the widest aperture possible instead of increasing the ISO sensitivity, regardless of whether you're shooting a portrait or landscape. If you must use flash, the XZ-1 lets you stop down the flash's power easily from within the flash menu, from full power to 1/64, so you can get more natural-looking flash that doesn't produce harsh shadows.