Databases can become corrupt, but I am not convinced that is the case here. The PAF software should still be able to recognize image files and link to them. Try linking to a newly-created or newly downloaded JPG file that is not in your media folder. (e.g. the one of me on my home page at http://billbuchanan.clawz.comhttp://billbuchanan.clawz.com) Can PAF recognize it and link to it successfully? If so, there is something wrong with your media files. For example, browsers support GIF image files, but PAF does not. (I can't imagine why anyone would use GIF format for photos, as it only allows 256 colors. But this format would exhibit the behavior you describe.)
If PAF can't link to the JPG file, put a backup of your database on a flash drive and restore it on a different computer. If PAF can recognize image links on that computer, your PAF software may have become corrupted and you will need to uninstall and reinstall PAF on your computer to solve the problem. Then you should be able to add media links to your present database.