You should definitely upgrade the graphics card, that's holding you back a fair bit.
Your current graphics card has no built-in decoding for High Definition content; that means the decoding has to be done by your main system processor which will slow everything down and decrease performance (and also likely lead to dropped frames / stutter on playback).
Newer graphics have specialized hardware to decode various HD video formats. When you play one of these video formats back in Windows, the Operating System off-loads the decoding task to the graphics processing unit (GPU) so it doesn't tie up your CPU. As a result, the format decoding can be done smoothly and much more efficiently without taking up critical system resources.
Also, your graphics card is not HDCP compliant. That means you will not be able to playback encrypted/protected High Definition content like Blu-Ray movies in full High Definition (either they won't playback at all, or they will be downgraded to a lower standard definition resolution).
You may also want to consider purchasing a Blu-Ray drive to watch High Definition BR movies, and lastly you may want to consider upgrading the PC to Windows 7 which includes a more up to date Media Center application (note: you may need to upgrade the graphics card before you can migrate to Windows 7).
@R, that is not entirely correct. Firstly, MKV is not a video format or codec, it is a multimedia container. A container can hold all sorts of different video formats that are encoded with any number of codecs such as H.264, DivX, xVid or Theora.
Lets assume the MKV you are trying to playback contains H.264 video (since H.264 is becoming a popular video format). If your graphics card has built-in H.264 accelerated decoding support and you use a software media player that will utilize the GPU for playback, then you can take full advantage of the graphics hardware to play your movie. Note that you might also need Windows 7 to utilize GPU acceleration in this case.