I've been bashing my head against this bug since I noticed it this morning. Filled out feedback to Apple, for all the good that does - it feels like a shot in the dark. So I've been toying around with some of my old wallpapers and even when the wallpaper is 320x480 my iPad 3 just makes it a blurry impossible mess. So I hit image.google.com and found a refreshed version of a particular wallpaper of mine and found a version that was 1280x1980. I tried that and the same mess, with or without turning the motion off.
So I figure, small images or big images all have this issue. So size of image isn't the right thing to think about. What is the correct thing is adjusting the canvas size. I opened up a new tab, went to Pixlr.com, uploaded my 1280x1980 image and then went to Image, then Canvas Size, I changed the anchor to the center square and set the new canvas to 2448 by 2448, yes, square, WTH. Then saved the image and then used iMessage as a mule to get it from my iMac to my iPad.
That worked just fine! I lost a little at the bottom, so that's what the square canvas size does, there is likely a "magic number" for the height but I couldn't find anyone who had a better number than 2448.
It's a pain to have to haul all your images back and forth, but at least for the iPad 3, this works. Works for me. Even with the motion bits left on. YMMV. Good luck!