I'm having the same issue. I can set any picture to be my background, but Vista will automatically stretch it to fill the screen. When I try to change the setting in the background menu, my background disappears completely.

Furthermore, it appears that the 'browse' function for that page won't accept pictures of any file type other than .bmp, .jpg, .jpeg, and .dib. This is a bit of a problem since according to Windows Help I shouldn't use .bmp (it's outdated or something) but .jpg messes up my picture with its compression. Thus when I convert my background to .jpg to avoid the stretching, the picture correspondingly gets some weired colouration (it's subtle, but still there).