This post on the Blogger In Draft blog describes the feature. It's built into the Template Designer in Blogger In Draft, so you'll need to use the URL "draft.blogger.com" to edit your site instead of composing as usual on blogger.com. I've discussed the Template Designer previously here and on the Erie Moose test blog.
Here are Blogger's recommendations for image size and format:
For images that fill the entire background, we recommend using a resolution of 1800 pixels wide and 1600 pixels high, and file size less than 200KB to minimize the loading time of your blog pages.I cropped my photo of grasses to 1800x1600 and compressed it to slightly over 200kB. They'll let you upload an image up to 300kB. If you like how it looks, try it on your own blog and let me know!