DDS files (Direct Draw Surface files) are used for the textures in NWN2. A wikipedia page explaining them is located Here.
From Rob McGinnis:
DXT5 is the recommended dds format for alpha-masked transparency textures, though DXT3 and DXT1,1-bit alpha also work. We use DXT5 because it yields cleaner masking and edge quality for things like plant fronds and grass. The mask goes in the alpha channel of the diffuse texture. Any model utilizing transparency needs to be flagged as such before it is exported. Information regarding the public release of our model exporter is not currently available, but we intend to make it available in the near future.
Programs which can interact with DDS files
nVidia tools Photoshop plugin:
DDS Converter program: