[DrPraetorious]

Is it possible to attach images in-line?

Here's how you handle this, in GIMP, which is what you should use. Photoshop, in addition to costing money, is inferior for this purpose (although it has other nice features which GIMP lacks for other purposes):

1) Keep all of your sprites in a format that preserves transparency, while you are working on them. This can be tga, but keep a transparency layer, and make sure that the background is alpha-0. You can achieve this by selecting everything that should be background and erasing it.

2) When you want to actually use a sprite, there are three steps:
a) Make sure that the background is set to true-black (0-0-0). Double click on the background box in the tool chest to set this by hand if needed.
b) Layer->Transparency->Threshold Alpha
This is the step that you were missing - or couldn't use because you were working on a black background instead of transparency from the begining. 128 (which means 50%) is generally the best setting to use but for an particular image you may want to move the threshold around and see if it looks better. If you do this *after* all rotations, partial transparent painting, etc. etc. ad nauseum, you'll see what the sprite actually should look like in-game.
If GIMP gives you bull**** about doing this, save the image as a .tga and then open it again.
c) Image->Flatten Image
This introduces a perfect black background. Since you threshold alpha before doing this, you don't end up with any really-dark-but-should-be-50%-transparent-pixels.

The game actually will accept a tga with a transparency layer, but I don't know how it handles it or whether it's possible to give such images shadows. Most of the older modders are used to the black-background graphics so that's what most people use. I also think it's what KO himself uses.