Flarum's "Add an image" button is part of the Markdown extension, it inserts the Markdown code to embed an external image.
If you have FoF Upload installed and configured, there will be a different file upload button on the toolbar, and FoF Upload also supports drag-and-drop.
I don't remember whether FoF Upload has an option to hide the Markdown image button if it creates confusion. You could always hide it with CSS if needed.
If you don't see the FoF Upload button, try clearing your forum cache and/or disabling and re-enabling the extension.
