The terrain editor works exactly like in UnrealEd 3.0 from UT2003/2004.
The only exception is that the heightmap cannot be created "on the fly" in the editor. You have to make one outside.
What this means is that you have to created a greyscale texture, import it, set it as your heightmap in your TerrainInfo and then, in the TerrainEditingTool, convert it to 16-bits.
I had a tutorial on my website for this, but it's currently down, so I'll run you though the basic steps. I assume you are used to creating terrains with UT2003/4.
Create your empty cube, add the usual zoneinfo with bTerrainZone = true.
Add your TerrainInfo.
At this point, everything you can do to your TerrainInfo will crash the editor. This includes moving it. One the TerrainInfo appears in your 3d viewport, do not use the viewports anymore until I say you can.
Open the Texture Browser and import an heightmap. This should be a greyscale texture with usual and additional limitations: size has to be a power of 2, the texture has to be square.
Once the texture is imported, open your TerrainInfo's properties by clicking the Open Actor Properties button (do not double-click the actor in the viewports).
Under TerrainInfo, in the TerrainMap field, add your newly imported texture. Rebuild the map, you can now use your viewports.
The TerrainEditingTool will then work just like in UT2003 and 2004, with two important exceptions:
1) It might crash randomly for no apparent reason. Save often.
2) You will not be able to alter the terrain's geometry (ie: the heightmap) with the sculpting tools such as Flatten, Painting, Smooth, etc. In order to have these tools work, you have to open the TerrainEditingTool, right-click on the Heightmap and select "Convert to 16-bit". This is supposed to turn your heightmap into a G16 texture which is 16-bit greyscale. However, this does not seem to always work. I suspect it can only change textures which are in specific formats. BMP seems not to work, so if the conversion fails to make any change, try with an imported .pcx heightmap.
Alternatively, and this would be my recommandation, you can skip this whole thing by creating an heightmap of the desired size in UT2003/4 through the usual process, leave it blank, export it to your desktop and import it into Unreal2. It will work fine and provided you don't crash the editor by mishandling the TerrainInfo, it will work flawlessly without the hassle of creating it with a separate tool and searching for formats which are OK with being turned into G16.
If you don't understand something, if you've never used UnrealEd 3.0 for UT2003/4 or if you need more details about anything, just ask, I'll be more than happy to pour pages and pages of explanations upon your head, I love this editor.