For those testing the feature, the image should be no larger than 100x120 pixels, or else it will be scaled down by the browser (which generally looks pretty bad). The image must be one of: GIF, JPEG, BMP, or PNG. Also, you are prohibited from uploading an image larger than 64KB.
All of these options, as well as the master option of whether or not to allow users to upload their own icons, are new admin settings.
Custom avatars are uploaded through the Basic section of your profile.