The scenario is, you have a custom install of WordPress and you’re trying to upload a blog post that has pictures included but you get the error “Picture Upload Not Supported by Blog”. WordPress does support this, so you have two options.
You can configure Live Writer to FTP the pictures to your blog. This solution works fine, but I’d rather fix the problem that caused the above error.
To fix the above error, you need to create an “uploads” inside of the wp-content folder in your WordPress installation. (yourBlog/wp-content/uploads). It’s very important that you then set permissions on this folder so the site can write content to it. If your web server is a unix/linux blend then you can use most FTP programs to set the folder permissions to 777. If you are using a Microsoft IIS web server then you’ll need to find a utility to set the permissions on the folder to read/write for both yourself, and the IUSR user that the site uses. My web host Brinkster has a utility available on their page that allows for these type of changes in their setup.