FIRST you will need Firmware version 2.0 which is currently available here.

1. Download the 2.0 firmware.
Transfer the firmware to your Memory Stick Pro Duo via the USB cable. Store the file named EBOOT.PBP in /PSP/GAME/UPDATE/
Boot up your PSP. From the "Game" menu select the "Memory Stick". Click on "PSP Update ver 2.00" and follow the on-screen instructions to update your firmware.
Once installed, your PSP will have several new features, including a web browser, and the ability to use images as your wallpaper.

2. How do I save wallpapers to my Memory Stick Pro Duo?
The easiest way is to simply mount your Memory Stick Pro Duo as a disk on your computer by plugging it in with the USB cable. To mount the memory card, navigate to the "Settings" menu on the PSP and select "USB Mode". Once the disk mounts, copy your 480x272 pixel images to the /PSP/PHOTO/ directory. If you want to, you could create a WALLPAPER directory in this location to keep things organized.

Now eject your Memory Stick Pro Duo from the computer and navigate to the "Photo" menu on the PSP. You should see your wallpapers here.

3. How do I save wallpapers to my Memory Stick Pro Duo using the PSP's web browser?

Save image to Memory Stick Pro Duo (/PSP/PHOTO/).

That's it. Your wallpaper is now saved on your Memory Stick.

4. How do I change the wallpaper on the PSP?
Once you have downloaded wallpaper from the web or uploaded them from your computer over the USB connection, you are ready to set an image as you backdrop.

Navigate to the "Photo" menu and press the CIRCLE button to select the "Memory Stick". This will bring up a list of your images. Browse to the image you want to use as your wallpaper, press the CIRCLE button to select it, then press the TRIANGLE button to bring up the menu. Select the "Set as Wallpaper" option (it's the second icon from the left, on the top row) and press the CIRCLE button.

You will be prompted to overwrite the current wallpaper (if any). Select "Yes" and press the CIRCLE button. Now press the X button repeatedly to navigate back to the main menu.

Your wallpaper should now be installed.

To turn off the wallpaper and go back to the default menu style, navigate to the "Settings" menu item and select "Theme Settings" and press the CIRCLE button. Down arrow to the "Wallpaper" option, press the CIRCLE button, then select "Do Not Use" and press the CIRCLE button. Your wallpaper should now be back to the default setting.