You "Can" upgrade a bit only, but mostly its true you need a new system.
In case you dont want to, here is my advice:
-Check PSU first, to know how much power it can handle.
-Get a nvidia gtx 460 768mb ram (cheapest version you can so that its somewhere close to your cpu effectivness. Also you could get this gpu cheap enought nowdays i think, and going a GTX260 seems a bit... strange now
. Remmber that Win Xp is a DX9 system if i remmber right, so unless you get vista, you wont get DX10 and 11).
-Get 2 extra gigs ram
-Get a good cpu cooler (futureproof would be best option) and oc cpu.
Now, i dont know if ati gpus can take off the physx off from the cpu in the current generations, but i know nvidia can.
Since your CPU is what will be the bottleneck, getting that extra work off from the cpu will get you some more headroom.
Thats my advice.