It's perfectly normal to get a lot of lag when you turn shadows on to high. It takes a lot from your computer to calculate how the shadows should show on the screen. Just turn it off and enjoy playing you game.
If you really want to play with shadows on high I would suggest to upgrade your whole system. If you put in for example a ati radeon 6850 or Nvidia 560 ti your CPU will bottleneck, and you won't get max performance.
I would like to thank all who replied to this post as everyone that posted help me come to a decision. For some reason though I'm not able to select the best answer. If you asked me, I think that everyone that posted on this thread gave me the best answer which is to save my money to build a new system.
I hope by that time I'll be able to save around $500 to build around a HD 7850 or nVidia equivalent which brings me to my next question. Which would be a good CPU to match this setup?