The two obvious things to check are:
1. Apache has write permission to the blogs.dir folder (or you have suPHP enabled)
2. You have the GD Library for PHP installed
If you can upload other avatars… like your own… then neither of the above are the issue and we (or rather… DJPaul) would have to know what the error message is in your logs. But those are the two most obvious things to check on first.