Ok, let me re-phrase that question...which should we use to achieve what I have described?
Is the File Manager function to allow people to upload images within their formatted text?
Also, you might want to have a look at the text on the page you highlighted:
...there appear to be some odd HTML sections such as step 4 in the Applying to your Update page:
4.Change <input type=%u201Dtext%u201D> to <input type=%u201Dhidden%u201D>.