Hello there! Hope you enjoy your stay :]
It seems you saved that picture as a GIF image... Next time, you should save it as a PNG image so the quality won't deteriorate.
To set your icon, go to the top, then profile > avatar. You should upload one straight from your computer because it is copied onto the site. If the image's link fails on another site, it will still work here because it was copied to the site.
Personally, I prefer Photobucket on uploading pictures because it doesn't delete your pictures over time, but, suit yourself. All three services (dA, Photobucket, and Tinypic) are free, so it's your choice.