This is a website configuration issue.
Several years ago, when I set up the website, I decided that "external links" would not be enabled. (part of my site security policy)
Thus, the "link" option will only work with "internal links" (files that are resident on the website server)
Thus, the "image button" is working properly.
However, I agree that the wording on the dialog box could be improved.
I'll have a look at this next time I do some site maintenance.
(FYI - the site has about 500kloc + lots of tables and stored procedures)
Ken