We study numerically the equilibrium shapes, shape transitions, and dislocation nucleation of small strained epitaxial islands with a two-dimensional atomistic model, using simple interatomic pair potentials. We first map out the phase diagram for the equilibrium island shapes as a function of island size (up to N=105 atoms) and lattice misfit with the substrate, and show that nanoscopic islands have four generic equilibrium shapes, in contrast with predictions from the continuum theory of elasticity. For increasing substrate-adsorbate attraction, we find islands that form on top of a finite wetting layer as observed in Stranski-Krastanow growth. We also investigate energy barriers and transition paths for transitions between different shapes of the islands and for dislocation nucleation in initially coherent islands. In particular, we find that dislocations nucleate spontaneously at the edges of the adsorbate-substrate interface above a critical size or lattice misfit.