If you're trying to upload a picture that is resident on your 'pooter, use the Attachments "Paperclip" icon instead of the Insert Image pic icon thingy.
That's correct - you can't upload attachments in a quick reply (all you can do is link to an existing picture somewhere on the internet), but if you click the "Go Advanced" button you can then scroll down and click "Manage Attachments" where you can upload files.