>XWE
There's your problem right there. You should be using SLADE instead, XWE is hilariously outdated.
Did you convert it to Doom Format? You have to convert sprites to Doom Format in order for the game to use them. You can do so by right clicking the sprite, going to the 'Gfx' submenu and hitting 'Convert to...'. If you're using SRB2 as a base resource, it should convert the sprite to the Sonic (SRB2) pallete. If it isn't, you can simply change what pallete to convert it to by selecting 'Existing/Global' and choosing it from the drop down menu.