Hi Bob,
I host all of my pictures on a third party site. My choice is
https://picasaweb.google.com (A Google product.) Others include Flikr and Imageshak (sp?) If you use one of these, you just need to figure out how to get the actual URL (web address) of the image and then use the image tags (furthest left button under text attributes on the compose screen.)
If I keep images below 800 pix maximum dimension, the storage on Picasaweb is unlimited. Not sure about the other services.
Edit: maybe try reducing the size of the picture you are trying to upload to make sure it is 800 pix max dimension. If you are on Windows, there is a program called Irfanview that is supposed to be good at this. I use The Gimp (on Linux) which also has a Windows version.
HTH