Hi Yarn Artiste,
The "Select an Image" box actually isn't located on the template creation page. We use the same editor for the lister page, so that message is intended for people who are adding images directly into the description editor when creating their listings.
To add images to your template in a manner that they won't be resized like the normal auction photos, using the "Freetiva Image" button is the correct way to do so.
A actually just tested this function out and I was able to successfully add images to my custome template without receiving the error message mentioned above, so you should be able to add images in this manner as well.
For further assistance with this manner, I receommend filing a support case using the appropriate link on our help page:
http://www.auctiva.com/free_auction_software_help/help.aspx
-Mike