When you apply the wallpapers, I'm guessing they display stretched?
Have you used an alternate home screen launcher? say panda home?, then decided to go back to the standard home?... I used a couple of alternate launchers, and I found they messed with the wallpapers of the standard home screen and also stopped you setting new wallpapers properly in the way you describe.
My solution as I remember is to either uninstall the alt home screen app you're using and then reboot the phone, at which point you'll be able to set wallpapers normally... or just to forget about the default home screen and keep using the alternate home app.
Another solution would be to install the 2.1 update, as this doesn't have that problem anymore, though you do have to have the same wallpaper for all your home screens, unlike in 1.6 where you can have seperate ones...