So majority votes option #2, eh?
No, not really..
I would upgrade only the GPU and do some CPU overclocking to ~3gz or even higher. Overclocking really isn't dangerous or hard anymore.. If you don't know how to do it, you can ask a friend to do it for you.
A 3ghz dual core CPU and a GTX260 or HD5770 would give a very good performance on your resolution if you don't push the AA/AF to the max. And buying only the GPU isn't too expensive. After all, money doesn't grow on trees.