How to Make Envelopes With Adobe Illustrator. Adobe Illustrator uses envelopes to create distortion effect for images. An envelope is a grid-like pattern of lines attached to an image; the content ...

PS CS 4 does support smart objects. I would revisit the workflow of dropping the picture into Illustrator. You should be able to distort it the way you like, just not with the free transform tool.

Understanding and using the new Envelope Distortion tools Integrating Illustrator content with other applications including Photoshop, GoLive, InDesign and Macromedia Flash.