Is there is something I'm missing? My textures always get stretched and distorted.
What you're missing is UV mapping skills. Learning to do it properly takes time. Even I'm not that good at it.
Alrighty then. Here's what baked ambient occlusion looks like in Blockland. The minor banding visible is caused by GIF compression. It looks fine in Blockland. Texture size was 512x512 but I'm quite sure it would look okay at 256x256 as well.
http://i.imgur.com/sRZ1wzd.gifhttp://i.imgur.com/MSLMlAZ.gifhttp://i.imgur.com/sPpuWFp.gifhttp://i.imgur.com/tHdojAE.gifhttp://i.imgur.com/oHYxYgw.gifAlthough if you're using texture quality below high you're forgeted.

This ugly blurriness and discoloration is caused by Blockland scaling down the texture. I might be able to forget with mip mapping in the DTS exporter but it's unlikely I can fix this as Blockland does not support .DDS image format which would reduce this discoloration somewhat. Without AO and doing the textures like literally everyone else does causes no blurriness or discoloration whatsoever on the weapon when you lower the texture quality. There is 0 difference between minimum and best. This is because what the game is doing is mapping a single color 16x16 PNG onto the model. Scaling down an image that only has one color does not causes the one color to get blurry or discolored.
But if you want to use AO (the easy way) you have a single PNG texture for the entire model
that contains the AO and all the colors on the model. (Lightmap packing for those in the know.) The usual method of coloring a model uses one PNG per color. Although the single AO texture is larger than the several color textures I doubt it is going to increase load times in any noticeable way. I'm also pretty sure you can't use colorshift if you do AO this way.
There is also a better way to do this that probably wouldn't cause any discoloration and only minor blurriness. I did the quick and dirty way because I was so excited. I'll look into the proper way of doing it tomorrow.