Graphics is definitely where you want to upgrade.
Check out Tom's Hierarchy chart below
http://www.tomshardware.com/reviews/gaming-performance-radeon-geforce,3018-7.html
I'd recommend any GPU in the tier of the GTX 560 or Radeon 5850/6870. From their it depends on your budget and what sort of deals you can find at the moment of purchase.
I prefer cards from EVGA with the -AR suffix because of the lifetime warranties. The fact of the matter is that in 20 years you won't want that GTX 560 Ti but the peace of mind is typically worth the extra $10 or so.
On the Radeon side XFX has nice warranties also, but the customer service isn't as good as EVGA.
I've seen deals on GTX 560 Ti for as little as $170. It is likely worth doing some shopping and get the best card you can afford.