My laptop only has a 40 gb memory and am starting to see messages saying that my system restore under windows xp will not work as there is not enough space on the hard drive.Given I need to upgrade my hard drive, is it better to replace existing internal hard drive or to buy an external hard drive and can someone recommend a reliable producer?

Both Sue and I have the Buffalo Mini Station external hard drive and have had no problems so far. It is easy to use (has to be for me!) It lets you know when and what it is backing up and runs automatically . The programme it uses is called Memeo, and was easy to download.
It's here

Regarding System Restore, I think restore points can only be written on the disk where the operating system is installed (I haven't read anything where is says otherwise anyway). So you couldn't use an external disk for that. However, you could start putting some of your files out to an external drive to free up some space for more restore points on the internal (C:\) drive.

It is also possible to reduce the amount of disk space that System Restore uses. Click the 'System Restore' tab in 'My Computer' and the click the 'Settings' button. Put the slider back from the 'Max' position. This will give fewer restore points though.

Even if you decide to upgrade the internal drive, a second drive is handy to have for backup purposes. I have a second internal drive and find it very useful for saving downloads to and using as a general storage/backup area.

I think the the 40GB figure mentioned might be the hard drive size rather than the amount of installed memory? You can find out how much memory is installed by clicking on 'My Computer' and selecting the 'General' tab. The memory figure is given as 'RAM'.