I use GIMP; needs a plugin for .dds though I think.
Paint.net is maybe easier, has .dds support build in, but don't know how to work with that.
For GIMP I just use "color to alpha" to make the background transparant, or use a selection tool to single out the image from the background, then either invert selection and remove or copy-paste into new image with transparant background. Save it with DXT3/5 compression.
Send me the image over FileFront or something and I'll rework it, if you don't know how to use the programs.