Ok. You're on a socket 775. You really should be fine with this pairing.
You can confirm this after you upgrade your CPU and run GPU-z while playing a more demanding game like BFBC2. Log your GPU's vitals in GPU-z. If you get slowdowns and stutters and your log file says your video card never nears the 100% utilization mark, you have a bottleneck.
This is something that generally happens at lower resolutions with older games.
I would say that if you're going to plink down more money for a CPU you might as well drop a few bucks for some more DDR2 RAM. It's relatively cheap, for an additional 2-stick set of 2GB for $27.99 shipped from Newegg.com here.
Ideally, for gaming you want to shoot for over 4GB due to upcoming games' high memory demands but if it's not in your budget today, get the 2 for now and get 2x2GB sticks later for a total of 6GB and you should be fine.
Here's the problem. Your GPU does reserve some VRAM, plus you have background stuff running... usually with no programs open just in Windows you'll be close to 1gb used. Now, Windows can use "file paging" which means storing RAM stuff on your hard drive, but of course this is a serious slow down. HDDs are around 1000x (more, actually) slower than RAM so you see your system being sluggish.
4gb is the least amount you should consider using these days, especially with 1gb video cards.
Other than that, should be a decent system if you upgrade to that E7200.
Well the problem is that I have this chipset http://ark.intel.com/products/chipsets/28994
which only supports max to 2gb ram.
So I guess I'm kinda stuck here.
Cannot increase the budget for mobo for now.
What if I install 2 windows , 7 and xp , and play games on xp as xp will use quite less ram compared to 7.
Also I will close unnecessary background programs.
So will this reserve enough ram for games ?
(btw is there any tweak by which I can install more ram ?? Just thinking)
Ex: I got an 8800GT 512 on a Opteron 144, and i get 40% GPU use on MW2 (maximum at 1680*1050), since the HD5770 got even better performance than the 8800GT, you can imagine how much your CPU is bottlenecking you HD5770