Instagraph gets around Instagram's API limitations by using a server side work around. Images are sent from the Windows Phone app to a server, which then submits them to Instagram on behlf of the user. The server is likely to be using an unofficial API or spoofing (fooling) the service by pretending to be an iPhone or an Android device.
Instagraph is being developed by Venetasoft, who have already published a number of Windows Phone apps, including Turbo Camera, Ultimate Recorder, and Security Toolkit. The app is currently in development and will be submitted to the Windows Phone Store in due course, but whether it will pass certification is open to debate.
Here's a video with a walk-through of the app:
Don't get too excited, or why Instagraph (probably) won't be around for long
Instagraph would almost certainly fail a rigid interpretation of the content policies for Windows Phone (section 3.1), which notes that it is an "application provider's responsibility to determine if the app provider has the right to use the chosen name, content, logos, copyright, trademarks, online services & APIs". That's because the app almost certainly breaks section 10 of Instagram's terms of service ("you must not access Instagram's private API by means other than those permitted by Instagram") and will likely also in violation of section 2 of Instagram API's terms of sevice ("you shall not use Instagram APIs for any application that replicates or attempts to replace the essential user experience of Instagram.com or the Instagram iPhone App").
Given the sometimes lax interpretation of the rules by the app assessment teams at Microsoft there is still a reasonable chance that the app will be approved and made available for download from the Windows Phone site. However, should that happen, it is unlikely that the app will be available for long. Should the app prove to be popular, which given its status as the only way of publishing photos to Instagram from Windows Phone is almost guaranteed, Instagram will almost certainly act to preserve its control on the photo sharing service, either by getting the app removed from the Windows Phone Store, or by blocking on the server side.
As such it is very unlikely that Instagraph will be a long term viable solution. Nonetheless its creation, and the surrounding buzz, does underline the demand for Instagram on Windows Phone, something that has also been demonstrated by Nokia's #2InstaWithLove app. Perhaps, Instagram might be persuaded that an official Windows Phone Instagram client should be made available (we're sure Microsoft or Nokia would provide development resources, if they haven't already done so, faster that you can say "apply this filter".