I am having this same issue after updating WordPress to 3.5.1 and Buddypress to 1.6.1 last night.
When trying to upload an avatar, I get this error message:
Fatal error: Call to undefined function wp_create_thumbnail() in /home/site-name/public_html/wp-content/plugins/buddypress/bp-core/bp-core-avatars.php on line 521
But if I use a small image (150×150) it uploads with no errors. The cropping tool did seem to be a bit out of sorts, but I got it to work by playing with it a bit.
So it seems that it is related to image dimensions, presumably related to the cropping tool??