By default Compute Engine instance uses key pairs to authenticate you into your instance. This is very much recommended for security reasons. When you are first time connecting your instance through gcutil ssh, you will be asked to create a pass phrase for your ssh keys. Gcutil will create key pair in your local machine and copy it over to your project.
However if you want to authenticate ssh from outside world using password, here is a simple step what to do:
Edit file /etc/ssh/sshd_config
Find this line from your sshd_config and change it to PasswordAuthentication yes:
# Change to no to disable tunnelled clear text passwords PasswordAuthentication no