Import pictures into a custom story?

[Traggey]

Solid diffuse is a setting in the material editor, where it originaly sais type: decal.
Click that dropdown button and choose Solid Diffuse.

Also as Silent mentions you can not simply rename the file from .png to .dds that will not work.

You need to get yourself Photoshop or the Gimp and download a .dds plugin which lets you export in that specific format. Use google to find these plugins to whichever image editing program you are using.