The error occurs when trying to open GD2 to adjust the image size and create the thumbnail, so it is no surprise that you don't have the problem when you don't create the thumb.
Unfortunately from my research it appears GD2 can be a memory hog for large image manipulation and the only solution is to increase the memory. If your host won't allow it, then there may be no solution webassist can offer short of trying to hand code a solution using imageMagic instead of GD2, which is supposed to handle large files better, but there will still be a size limit based on the memory available. Image editing takes a lot of memory... it is easy to see that when you open a program like photoshop or fireworks and see how much memory they take.
Did this help? Tips are appreciated...
