Why can't you insert an image for a menu item?
From Joomla! Documentation
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Joomla version 1.6.2 has a bug that prevents you from inserting an image into a menu item using Menu Item Manager: Edit Menu Item. When you press the Select button for the Link Image field, select an image, and then press the Insert button, the screen doesn't close. Also, the Cancel button does not work correctly. It actually saves the selected image. (Because of this, you can use the Cancel button to select an image, and you have to use the Clear button to clear a selection.)
This bug has been fixed in Version 1.6.3.