Strange. The way it works makes me wonder if it's even supposed to work. The fact that you end up with both a shape and an image is definitly a bug or something. But it works.
I did some experiments, and at first I had the same issue you describe. Then I tried a smaller image to paste (a screen shot from my Apple Watch), and it worked. So I went back to the problem image and downsized it using a shortcut I often use for websites that don't like full sized images. That also worked.
Just to make sure it wasn't a combination of both image sized, I tried pasting the full sized image into the smaller (watch screenshot) image. Not only did I get the error, but Photos crashed.
So the answer is to make the image you want to paste smaller. It doesn't have to be a whole lot smaller. The shortcut I used decreases the image size by about ⅔.
Of course, Photos does not have a tool for resizing images. The options I can think for are;
1) Use a third party photo editing tool. Most of these will let you both import and export to the Photos Library. My goto app for this kind of work is Sketchbook. I't overpowered for this simple stuff, but easier to learn than the other power drqeing tools like Pixelmator, Procreate, and Photoshop.
2) if you don't need the whole image, crop the image to be pasted. It will be smaller, in a few ways.
3) Use a a shortcut action like I do. Shortcuts have several tools for resizing, changing image formats, and other stuff. My shortcut copies the smaller image back to Photos. Ideally your's would copy it to the clipboard, so you could continue as before.
4) Look for a resize utility that has an extension that works in Photos. When you edit a photo, there is a three dot icon next to the pen icon. You'll find an Extention option there. Some apps will offer limited tools inside the Photos app when installed. The apps I have that do this are Slor, Pixelmator, and Annotable. Unfortunately, none of them offer resizing options.
Note; The Shortcuts option has me curious. I may play around with it and see what I come up with. If I think you'll find the result useful, I'll post the link here
.