During the very late stages of development for the last version of Windows Live Writer we found a bug on our 'Insert from Web Image' dialog. Specifically there was a bug that prevented users from inserting images that that were part of libraries. This forced us to make the decision to go back to the standard OpenFileDialog instead of using the hacked up open file dialog we with the tabs which was in all the previous versions of Windows Live Writer.
This of course resulted in no more user interface to allow people to insert images that are already on the internet somewhere. At the time, Joe Cheng and I rationalized that this was fine, we thought that very few people knew where this dialog was anyways, and the power users that did know where it was could use the HTML source view to add in the image tag. This turned out not to be true at all! Shortly after we released Windows Live Writer 2009 we started seeing blogs, tweets, and forum posts asking where the tab on the open dialog had gone for insert an image from the web.
Well, I am here today to tell you there is a simple solution to your problem which should ease the pain until we are able to add the dialog back.
Simply copy the image from any browser:
Then paste it directly into the editor, Windows Live Writer will automatically convert it to the correct HTML for you, as seen below: