If I reduce my original image to 800×600 before uploading, I no longer get this error. I didn’t change anything else. I did go back to version .96, for now.
I am using WordPress 2.5.1 and the default theme.
I am having the same thumbnail problem.
There is no “max-width: 100%” line in the default theme that I can find, in the style sheet under Theme Editor.
There must be another problem.
Anyone?