After several attempts to debug the upload issue, it seemed that there is a chance that the problem could also be with the nodejs server.
I know nothing about nodejs, so at that point I threw in the towel and decided to just bite the bullet and completely reinstall my Ghost setup from scratch on the blog/ sub-directory… After taking suitable backups of course! (Even with backups I found that I still had to re-upload the images.)
For those who attempt the same thing, I found that I had to completely delete the MySQL DB as even after the ghost uninstall the DB still had the records from the previous installation. To do that I followed the steps here.
The site is now finally working as I want it.
Conclusion? If you are thinking of changing your existing ghost site to a sub-directory, be warned: thar be dragons! 