When trying to upload (attach) an image to an Image node, I would get an error concerning 'could not copy ...' with a path. Everything seemed fine.
Seems that this has happened before:
http://drupal.org/node/84405
In essence you have to turn OFF image attach for image nodes... a bit counter-intuitive, but...
Go to admin/settings/content-types/image and disable 'attach images' and 'attachments' (if applicable) for image nodes.