G16 is the way to go.
My experience with it worked like this...
Starting from importing the image inot UEd....
My image was 128 x 128 so I went through the steps of amking a 128 x 128 terrain. Then I added 1 terrain layer.
Then I opened the texture browser, made sure my imported heightmap was selected.
Then I opened the terrainactor properties from the terrainactor itself, and replaced the image under 'heightmap' with the newly imported one I had selected in the texture browser.
Once I'd done that, I closed the properties window and rebuilt.
Once the image is imported, to be editable, you need to change the image type to G8? if I recall correctly. And then you can go on and mess with the standard terrain tools (paint, smooth, flatten, etc...)
I hope that helps... Good luck!