Lets compile a list of applications people can use to create content for unreal.
I have listed some applications. Please add to it.
Try to keep in mind that most people are hobbyist and can't afford $1k+ for applications.

http://usa.autodesk.com/adsk/servlet...112&id=7639525 -Maya PLE, limited but will do what you need for unreal, free
http://www.blender.org/ -capable, but has the interface from hell, free
http://www.wings3d.com/ - very easy to use, like it a lot, free
http://chumbalum.swissquake.ch/ - milkshape, very good for games,interface not the best, $25.00
http://www.daz3d.com/i.x/software/hexagon/ - good, builtin renderer ,$149.00
http://www.nevercenter.com/ - silo, very easy to use, powerful, I use it over max/maya for modeling, $159.00

I have only listed what I have used personally.
I listed the applications for under $200
There are plenty of great programs like modo, zbrush, xsi, lightwave, but they are all over $500

All the above have trial downloads, so I would try each one to see which fits you.

Unreal likes its meshes to be in ascii format.
Blender, milkshape, maya - have ascii support.

If you like a program that does not have ascii support you can use the maya PLE to load in the model and save it back out.

2d paint/photo programs

Of course photoshop , but its expensive.
http://www.gimp.org/ - supports lots of photoshop features, free
http://www.pixarra.com/ - twisted brush, paint program, good features, free
http://www.thebest3d.com/dogwaffle/ - dogwaffle, not well known, but very powerful paint program, free

Thats all I can think of right now.
Please add to the list !