This part was explained to me some time ago by an attorney. Sort of paraphrasing here....

Apparently this is a common clause which allows SL to distribute the images generated within Second Life. If they were not allowed, only you would see any of your creations, everyone else would see you as a default figure. That is why it says... *your Content within the Service as permitted by you through your interactions on the Service,

the within the Service is the key.... If you look at your ISP, many Web Sites, etc... that allow upload of images, you will see this type of language. It is what allows them to display what is uploaded. I recall many of the Galleries going through changes in their TOS and this type of language needing to be clarified.

The question here is if the person using any Derivative, even for personal use within SL, has the right to display or redistribute any such content in accordance to this agreement.

Quote - you guys are missing something:

“…you understand and agree that by submitting your Content to any area of the service, you automatically grant (and you represent and warrant that you have the right to grant) to Linden Lab: (a) a royalty-free, worldwide, fully paid-up, perpetual, irrevocable, non-exclusive right and license to (i) use, reproduce and distribute your Content within the Service as permitted by you through your interactions on the Service, and (ii) use and reproduce (and to authorize third parties to use and reproduce) any of your Content in any or all media for marketing and/or promotional purposes in connection with the Service;”*"

ratscloset
aka John