I'm not sure what you are asking. If you are trying to post pics with the attachment system, it will open a file search window for your local hard drive. If you are trying to use the IMG bbcode tag, you have to upload your image manually to an image hosting site like tinypic.com first and then post the URL that the site provides.
ancona - the stuff for uploading an image straight to here doesn't show up till you go advanced, click the paperclip icon, then you can nav to your computer in a window it pops up. It has serious limits and doesn't work that well - PMBug needs a bigger disk and looser settings (the board auto-craps-up those images and won't take big ones), but it does work at all. The insert pic button you see in normal mode is only for putting in an image url of an image already available on the web somewhere, as PMBug says.
Right. As DCF mentions, the insert pic button is trying to help you insert the IMG code. I'd suggest opening a second browser tab to tinypic.com to upload the images and then grab the IMG/forum code from the upload complete page. That's what I do.
The problem you're going to have with this, as I have on my own sites, is what happens when someone finger-fumbles their flikr or tinypic account and wipes out the linked picture. Now your board is broken too. It's much better to keep the stuff yourself, onboard as it were if you want it to have any lasting value. If not, you should probably just delete threads after a certain age as they're all going to be broken anyway. Something to ponder...
My ISP, iPower, doesn't charge for the extra storage this requires, at least not so far, and I've been doing business with them for about a decade now. It's so cheap, why not? I usually re-up for 3 years or more at a time, and it's trouble free.
For example, here's a pic, hosted on my own site. What if I decided to change it to, say, child porn without telling you - and you get in trouble because you don't have time to check every picture link every day for your whole site.
This shows an interesting blip in gold at 10:03, as mentioned on ZH yesterday, FWIW.
You'll have to scroll to the right to see that trade by trade. Look how easy this makes it for
a member to screw up your site!
My point was of course, that this way of doing things adds points of failure you have no control over (gee, reminds me of fiat money!). If a user here gets hacked - you're hacked too in this regard. Like having a vault with more than one combination that works to open the door.
Edit - just to drive home the point, since I know you saw it, I just edited that image on MY site...and it's changed here.