It sounds like you're using a mid 2007 iMac, not the 2008 model. I have a 20" Mid-2007 iMac 2.4 GHz C2D with the ATI HD 2600 Pro (256mb) card with 4GB RAM. I'm running Lion and WinXP (bootcamped).
While this computer is not nearly as zippy as the new iMacs, it still runs very nicely.
I'd say that your problem would either be the hard drive, or, frankly, a lackluster video card. That, along with VLC not always being the most stable of programs anyway... is your problem.
Otherwise, Lion should run just fine under 4GB Ram on your system. At the moment my system is running top notch and I'm only using 1.8GB of my RAM. When I run Civ 5 under my Mac partition, about 3GB are used. I've never actually really maxed it out.
A few things you can do to aid performance:
Clean up your desktop. Move any stray files into a folder. If you can live with having to click on the desktop background and holding down cmd+n to bring up a new finder window and select your hard disk, de-select the "show internal hard drives" and "external hard drives".
Go into your dash board. Remove all widgets you don't regularly use. That language translator widget might be better off gone and replaced with a quick bookmark link to an online translator in your web browser.
Go into system preferences and under the "System" tab, click on "Users and Groups". In that window, select "Login items" at the top. Any programs that you don't use regularly or don't necessarily need to be loaded upon startup should be selected and removed from the list. These programs take up valuable memory and can hog processor function as well.
A nifty little hint I got from somewhere is to open Font Book. Make sure "all fonts" are selected in the left hand column. Under the file menu, click "validate font"... it will bring up a list of any fonts that are corrupted. Because every program or application you use uses fonts, a corrupted font can slow down your system. Delete any corrupted fonts and close Font Book.
If the system is still very laggy after this, I'd go for the new hard drive. I've replaced the drive in my own iMac, which is probably almost identical to the one you have. If you have any questions on how to go about it, feel free to ask. There are also multiple guides online that detail the process step by step.
You can also increase your RAM to 6GB. This is not supported by Apple, but you can install a 2GB and a 4GB 667MHz module. Mismatching the size of the modules can mean a slowdown in memory performance, but is more than made up for by the extra memory if you are using a lot of memory intensive applications.
If you're not using most of your RAM much of the time, 4GB should be plenty.