I think of three possible causes for the problem.
1. There is something wrong in the /home/user/.kde file tree. Since you have the same problem with root then a corrupt .kde is not the problem.
2. There is something wrong with the format of the jpeg files you create. You could try using some jpeg images from some other source and see if they also have the problem.
" I have tried a lot of file types, but they all seem to not work in the desktop[ config."
If some of your tests were run using other people's images then you have already tested this possibiliy.
3. There is a bug in your version of KDE. Unfortunately KDE comes as a complete set so you cannot just replace the desktop display program with a latter version. To test if your problem is a bug in KDE you would have to upgrade the entire KDE, Qt3, arts, and some libs to the latest version of KDE (KDE 3.1.4). This is a lot of work and may turn out not to solve the problem.
Be prepared. Create a LifeBoat CD.