For larger images use the 3rd option on edit avatar;
Link off-site:
Enter the URL of the location containing the avatar image you wish to link to.
Find an image you wish to use and copy the link eg.
http://www.decalsusa.com/images/hello%2 ... 0decal.JPG

And the image should just upload if its valid.
Photobucket and Deviantart are a couple of sites which are useful for hosting your images.
Use the avatar dimensions to ensure that the image is within the 150px by 150px:
Specify the width and height of the avatar, leave blank to attempt automatic verification. px X px
You can also use this to adjust images that are stretched.