Seems like it's a problem with the htaccess - removing it from the images folder makes everything work again, even if watermark.png and wrapper.php are still in the admin folder...
Also, adding back in the gif and png lines to the htaccess file and putting it back in images makes no difference.
Hmm. Any ideas? I don't even know what htaccess files do, so I'm at a loss now!
Just to be totally clear, here's what I've done so far.
1) Created a watermark.png file in Photoshop and placed it in public_html/admin
2) Put the wrapper.php file, unedited in any way, in public_html/admin
3) Changed the .htaccess file and placed it in public_html/images
The .htaccess file contains the following and nothing else, not even blank lines:
AddHandler watermarked .jpg
AddHandler watermarked .jpeg
AddHandler watermarked .gif
AddHandler watermarked .png
Action watermarked /admin/wrapper.php