Yes this seems like the core issue. Images do not look like a quoted note in damus. This would still break images even if we implemented a kind viewer for it. It would break images in all other clients as well.

I feel like this could work fine on Damus with a little tinkering. When Damus initially received and renders an event that mentions a file attachment it can show it as a note mention, and once it pulls in the note and sees that it’s an image file it can upgrade the display of the note from inline note mention to an inline image. If the transition can be done smoothly without screwing up your scroll position it would be nice. It’s definitely more complicated than regular inline image URLs, because now to render you need to have both the text note and the file attachment note, but it’s not impossible.