Are you running Windows without a key? One of the main drawbacks to doing so is it limits these kind of personalization features.
I am unable to set a desktop background. If I right click on a .jpg and select 'Set as desktop background', nothing happens. When I go to Personalize and Browse to photos to use, I don't see the image. I see a square. I've checked Local User Policy and Registry to see if something has blocked that, but can't find anything.