SEO dilemma while setting up blog

The short answer is: depends, but with modern search engines, it probably doesn't make much difference. Search Engine Journal has a fairly good article on this topic.

I would argue that it should follow the convention of the rest of the site. So, for instance, if your site has http://www.mysite.com/learn/, http://www.mysite.com/explore/ and http://www.mysite.com/meta as major portions, use http://www.mysite.com/blog/. If it has http://learn.mysite.com/ and so on, use http://blog.mysite.com/.

I personally follow the one-subdomain-per-major-product-group philosophy, and the blog covers all product groups, so I give the blog its own subdomain. YMMV (Your Mileage May Vary).

dated - but another good article from SEOMOZ

99% of the time a subfolder is the proper way to go. If you are launching an entirely different product (maps.google.com, translate.google.com) then subdomains are the right way to go.

I hate to point to another moz article, but this one is a bit more recent and talks about why subfolders are generally preferable to subdomains - http://www.seomoz.org/blog/understanding-root-domains-subdomains-vs-subfolders-microsites.

Matt Cutts from Google wrote a good article about this on http://www.mattcutts.com/blog/subdomains-and-subdirectories/:

My personal preference on subdomains vs. subdirectories is that I usually prefer the convenience of subdirectories for most of my content. A subdomain can be useful to separate out content that is completely different. Google uses subdomains for distinct products such news.google.com or maps.google.com, for example. If you’re a newer webmaster or SEO, I’d recommend using subdirectories until you start to feel pretty confident with the architecture of your site.