A tree-style selector makes sense interface-wise. Expand the branches until you arrive at the image you want to use. Then any sub image could be used as the thumb for any album.
Implementing that could be a bit tricky, but you can imagine several ways, most having Javascript to make it work.
1) A select menu of images + subalbums (like the current) .. if a subalbum is selected, display the subalbum's selectbox below and open it. (AJAX would be best used here so you don't have to initially load the whole folder/image tree). Recurse.
2) An "expanded select" image selector with little + or > arrows next to subalbums, which expand the subalbum trees. Select any image at any level.
3) Mac OS-X style folder selection, where selecting a folder opens the subfolder to the right, showing again images and subalbums. Rinse, lather, recurse.
4) ??? Any number of possibilities.
All of these would set a hidden field with the value of the image folder+filename to use, which would then be stored in the db.
I prefer #2, it'd be a sort of custom widget, but not difficult to implement given Scriptaculous's list controls. If we want to stick to regular old HTML widgets, then the cascading select boxes would work as in #1.
I could implement this sometime soon. We'll discuss at the meeting. Is there a Trac ticket?