Could be the image resizing function has gone skewiff.
Are you seeing this error everywhere that you can upload files (media manager or w/e it’s called these days) or just with the in-line editor?
If it were my site:
Reinstall the core (stock theme, no plugins) and test upload.
If it works, add theme and retest then add plugins one by one, testing at each addition.
If it fails during something you “really, really, really need” then downgrade WP and wait for the theme/plugin dev to update her code.
You could do these tests quickly in a fresh development domain (using a free .dreamhosters.com subdomain)