well there are a couple of options here.
First; A disc imaging program might suit your needs, but I doubt it as you say there is a problem. The way this works is by making an exact copy of everything on your machine into a compressed image that can be restored at any time to another disc of what ever size as long as it is larger then the data contained within it. This might be a good solution for the back up, but I'm not sure it will save you much space. Programs like Ghost work great cause the chomp the image every 2Gb, so that you can store it on media.
Second; If you don't make an image/copy, then you will have to start over. That is the problem with starting over. If you reformat and reinstall XP then you will have no choice but to reinstall all of your apps. Besides, this is what you want to do to get rid of any problems that were present anyway.
Third; That link describes in detail everything you need to do for the "Files and settings transfer wizard" so just follow it. It's pretty straight forward, but if you run into trouble, just ask. It would be a good idea to do it as it will capture all of your configurations to the environment, as well as files you have created in your profile.
To reformat, you should boot the system with the XP cdrom in the drive, and delete the partition that present, then create a new one and format it again. That will start the drive over. Then you need to just install XP and the rest is history...
If that doesn't work, there are several boot disks that can be downloaded to assist you.
This site has a ton of info on making boot CDs and disks.
has all the boot disks you could ever want. Some work better then others, but they are all here.