I use a module called IMCE to upload images via Drupal. It is a neat plugin that works with TinyMCE.

When installing IMCE with Drupal 5, remember to copy to this directory: drupal/sites/all/modules/ rather than the main modules directory under drupal/modules. This path has changed since Drupal 4.x

I had some problems installing the TinyMCE editor tool with Drupal 5. Anyway, it seems the theme I was using for the website was causing the problem. You can read more in this Drupal forum discussion.