You need the Photoshop DDS plugin, to work with .dds files.
You can donwload the actual version directly from nVidia: Adobe Photoshop Plugins
Because that verion does not work with my PaintShopPro X, I need the old version 5.36, which you can download here: Photoshop_DDS_Plugin.zip
Open the image you want as avatar. For best results, select one with a motive, which hasn't too complex edges to simplify the creation of the selection. See Defining the selection.
For my tutorial I choose the car from the cover of Trackmania Sunrise: 
Now cut the image to that section you want to have as your avatar: 
Serenly leave some pixels as border.
Now we must select the motive. pick the Freehand selection tool, or if the motive is well distinguishable from the background the magic wand.
In most of the cases the image won't have the right pixel dimensions for an avatar. Therfore we have to manipulate the size to 128x128 pixel.
Probable the image isn't even square, but that's not a big deal either. ;-)
So first we resize the image to a maximum size of 128x128 pixel. My sample image then has the dimension of 128x79 pixel.
Assure the selection hasn't gone during the resize. In Photoshop you have to save your selection first, then resize and finally reload the selection.
I'm creating the selection before resizing, because it's easier to work on the bigger picture and the selection will be more accurate.
Now change the canvas size to 128x128 pixel.
If we let the selection as is, the avatar will have too much contrast on the background in TMN and this looks not very good.
Above all we still have the shadow below the car, which should become slightly transparent, like a real one.
So, first we make the border of the selection feather to have a smooth gradient of transparency.
In PSP X I choose Selection » Modify » Inside/Outside Feather.... To avoid pixels outside the motive, select the option Inside and then a value of 2 pixel.
Now we are ready, if we hadn't the shadow left...
Create a mask out of the selection by Layers » New Mask Layer » Show Selection auswähle.
This should look like this: 
To show you the mask better in contrast to the red car, I changed it color from red to green.
Again pick the tool Freehand Selection and remove all, but the part of the shadow from the selection. Because we don't create a new selection we still have the feathering effect at the bottom of the slection.
Still with the mask layer active, I fill the selection with 50% black. Not very satisfied i activate the normal raster layer and fill in the same selection 100% black. That's better for sure. :-)
To have the DDS plugin using the masks transparency we have to save the mask as alpha channel: Layer » Load/Save Mask » Save Mask to Alpha Channel.
Be aware all black pixels will be fully tranparent. The more apixel lightens up the more it will be opaque.
This little step is really easy.
Just save your file as .dds filetype in the TMN folder GameData\Skins\Avatars\.
You will be prompted with an options dialogue, normally you don't have to change an option, but to make you sure which options i selected here is a screenshot:
Ready!
Just open TMN, go to your profile, click onto your current avater, which presumably will be a our nations flag and select your just created own own avatar.
To have other see your avatar, you have to open/forward port 3450 (TCP+UDP) in your firewall/router. Keep in mind TMN is very slow transferring custom data. After you join a server play two or three matches before you ask if someone can see your new self created stylish avatar. (if you aren't asked for it already. ;-) )