Alright.. I found out something.. As long as I am running Nautilus, the background image shows up. But the unrecognized picture thing still exists. I will try and tell you more about it.
I tried to open the *.png image in the GIMP (while in GNOME) and it doesn't recognize it either.. I check the File Types and Apps. and png is listed. I'm still sort of confused.
I closed Nautilus and the background still exists. ??? I don't know why. However, the picture problem still exists