Your pic has to be hosted on another site. The image button is the one to use. Edit in the signature settings.
Basically, what i do is, upload my desired photo onto Friendster, right click on the image and copy the url and paste it after pressing the IMG button. You also copy any picture url on the net. Hope this helps.
Please be reminded that your signatures should be 640 pixels in width. Anything bigger than that will be removed by the moderators.