Hi, I'm one of the developers of Windows Live Writer. WLW should be able to upload images to WordPress--if not, I can help you figure out what the problem is, just e-mail me at joe.cheng *AT* microsoft.com.
Or if you prefer, you can configure WLW to automatically upload images via FTP. Just go to Weblog | Edit Weblog Settings | Images, and click the FTP option.
Are you kidding me? First I get an email from a WP plugins guy with detailed responses to all the problems and issues with that 5 star plugin.
Now we've attracted the interest of a Windows Live Writer Dev?!
What's next? Apple representatives for us mac users when we're frustrated with our machines?
Not that I'm upset or anything. I'm just a little surprised that our little community seems to have an eye on it from developers, heh.