AV is sadly one of those things where most people get totally fleeced.  A few rules of buying AV equipment:

1. Don't buy Bose or Bang/Olufsen.  You are paying for their advertising budget and hype.
2. Don't buy monster cables or any other boutique cable.
3. To save cash get all your cables and adapters at monoprice.com or bluejeanscable.com.  Monoprice is really barebones, as cheap as it gets.  BlueJeansCable are pretty much the best cables that you can buy at reasonable prices (Basically what a sound engineer would use).   
4. Video is very complicated right now.  The format wars are over, but blu-ray is still expensive and most people are happy with the quality of DVDs.  If you are considering an upgrade of your home theater system i would recommend upgrading to a quality surround sound system and waiting a couple years for 1080p TV sets  and blu-ray players to come down in price.
   

Speakers

The most important component in your system are your speakers. And for speakers there is a clear choice.  Axiom Audio.  

They have speakers for both small and big budgets, but they are truly an excellent audiophile grade speaker at reasonable prices.  Depending on the size of your room you can get a surround sound experience that rivals a movie theater for ~$1000.  For a small space, i recommend starting with a pair of M3's and a pair of QS4's.   Make sure you follow the guides for speaker placement offered on their site.  (and see above for speaker cable!)

TV/Monitor/Projector

I currently use a Dell 24" monitor for all my tv and movie watching.  It is a bit small, but it is widescreen and has amazing resolution (1920x1200, higher than 1080p).

A couple things to consider when buying a tv. 

1. The inputs to the TV.  A new TV should have HDMI inputs.  Unfortunately, HDMI is a horribly confusing standard.  As of this writing, the latest version of HDMI is 1.3a.  Unless you really don't care about having modern technology I would not get a TV that doesn't support HDMI 1.3a.  Also, most salesmen no nothing about the technology.  Use the web.  Cnet.com is a great source for AV buying advice and specs.
2. The resolution.  The current gold standard for High Def TV is 1080p, which means 1920 pixels wide by 1080 pixels high.  The p stands for progressive.  This is a nice article from our friends at axiom about choosing a TV.  The general rule is that you should sit around twice the screen width away from your TV.  So if you have a 42 inch set, you should sit about 84" (or seven feet) away from your TV.  However, your room setup might not allow you to follow this rule.  If you can sit at this optimal distance, you should get a 1080p screen.  If money or ergonomics mandates that your viewing distance will be more than twice the screen width, you might consider getting a 720p screen, that has lower resolution, since you will be too far from the screen to really see the difference.
3. Is your cable HD?  If you cable is standard resolution, then your new TV will look good with blu-ray or upconverted DVDs but might look like crap with your tv shows.  Check online to see how well an HDTV plays standard television.  This is sometimes called upconverting.
   

Receivers

Receivers are important components of your home theatre system and unfortunately i don't have a simple answer for which to buy.  They are the hub of the system.  Your inputs (DVD, playstation, cablebox, iPod, computer) are connected to the receiver and then you pick which input to be active and routed to your speakers and TV.  The worst things about receivers is that the more features you get, the harder they are to use and setup. 

1. With the advent of blu-ray there are a host of new audio formats that a cutting edge receiver needs to support.  If you want to be on the leading edge, Denon-3808ci is a pretty good one.
2. If you are not ready to go blu-ray and you just want your DVDs to sound good, then you can get a 'last generation' system without too many bells and whistles like this Yamaha HTR-5860.  It has no HDMI, so it really is not future-proof.  I am personally using a super cheap Sony STR-DE575 which i bought on ebay for $150.  It is very simple and it works. Doesn't have a lot of bells and whistles.