That's not how you find the photos in an iPhoto library to add to an email. Use the Media Browser that's in the new mail tool bar.
If it's not there then go to the View ➙ Customize Toolbar menu and add it.
Or, after setting up Mail as your email client in iPhoto's General Preference pane,
select the photos you want to email use the Share buttons and select Email
For more info on accessing photos in an iPhoto liblrary see this User Tip by Terence Devlin. It is the best treatise on How to Access Photos (for use outside of iPhoto): How to Access Files in iPhoto
NOTE: you should not access the photos in the iPhoto library from the Finder as you have in your screenshots. That can easily cause damage/corruption to the library.
Thanks for reply...
It sort of helps.
I do have the photo browser in the Mail toolbar. When I click on that I get the same dialogue box as shown in original post (the second screen shot). Same problem... even with iPhoto open, I cannot see the photos to select them. I know that photos can be shared through iPhoto itslef, but surely I should be able to do it through Mail as well.
Any other ideas?
If you're getting a Finder window when you click on the Photo Browser button in Mail then the problem lies with Mail not performing as it should. Not sure of the fixes for that but you can try moving these files to the Desktop, rebooting, launch iPhoto and then Mail.
These files are located in your Users/Home/Library/Preferences folder.
NOTE: In Lion and Mountain Lion the Home/Library folder is now invisible. To make it permanently visible enter the following in the Terminal application window: chflags nohidden ~/Library and hit the Enter button - 10.7: Un-hide the User Library folder.