Under the ste preferences you specify the root folder for the site, if the picture you are deffinetly trying to insert is sitting there then not sure. However, does it not give you the option to copy the file to the root when this message appears? As long as you make sure you upload this image to the folder it should be in on the web server it might not make a big difference.
"Stupid isn't not knowing the answer, it's not asking the question