This might not be the best solution but it worked for me. If you get an Application Error message when trying to upload an image to a blog Post then you need to open up the secuirty on the images folder which is usually locatioed at App_Data\files. So what I did was added Everyone to have full access to that folder and I was then able to upload files. I had this problem a while back to but it came back, probably because I moved the website or upgraded BlogEngine.NET.
Hope this comes in handy for someone.