ok here's what worked for me (although I was not getting the error you got):
-resized a jpg so it was about 27k (not sure if there's any file size limitation)
-sent file in an email from my outlook account
-rec'd email on my iphone
-long pressed on image, selected 'copy'
-went to iphone settings, mail contacts calendars, signature
-***after my normal signature text, I hit the return key several times
-went back up just under the signature text and hit paste
this seemed to work for me. the first time I tried it looked like it tried to copy the image, but didn't display in the signature or emails. after I hit the return key a few times then pasted, it worked. hope this helps but it might not since again, I didn't get that error msg.
do you know what file type you are trying to use? jpg, png, bmp, etc....?