the file "/boot/initrd.img" is linked to the *current* default boot image. If you update your kernel, it will be linked to the new image, but you will still have the old image available, in case the new one doesn't work. So each instance of the kernel gets a separate entry in LILO, with the default pointing to the latest.
Thus, with only 2.6.3-7 installed, you have an entry for 2.6.3-7, and one for "linux", the default, which *also* points to 2.6.3-7.