When you're setting the mapserver to type="feature", the data gets downloaded to the web browser and rendered by the Flash Player. This will draw the features, but not any labels. As a side note - if you're using a 9.3* server, the features will be drawn with default symbols. If you're using a 10* server, the features will be drawn with the symbology you set up in the service (mxd or msd).
If you set the type to "dynamic" (or "tiled" if it is a cached service) and change the URL to the full service, i.e. ending in "/MapServer", then the actual image will get created by ArcGIS Server (with labels).
However, the info popups only work for type="feature".
Hope this helps explain what is happening (or is supposed to happen).