Unfortunately hard drives do have a limited life due to their reliance on a spinning disk, motor and moving read/write heads. Directory damage can be due to corruption of the logical data structure on the disk or to a mechanical fault in the drive, usually drive failure is a bit of both.
Making a bootable clone of an already damaged system isn't really going to work so I'd start off by booting the Mac from its original system DVD. If this works then run Disk Utility from the Install DVD. If your Mac boots correctly from the system DVD and Disk Utility is unable to effect a repair then you'll be looking at a replacement hard drive which, on an iMac, is best done by Apple or an Apple authorised repairer as it involves quite a bit of stripping down including the removal of the screen.
If you can get it to boot from the system DVD then it's possible to do a reformat of the hard drive and then re-install the system but, to be honest, with a 3+ year old drive already showing directory errors I'd certainly plump for a replacement drive and, as a large part of the cost is for labour, use the opportunity to have a larger capacity drive fitted or go for a solid state drive with no moving parts but a much bigger price tag.
Bob.