Updating the ipod touch
As commenters above suggest i Tunes will only backup configuration files and whatnot.
All content is supposed to be available in the i Tunes library with which the i Pod syncs, so i Tunes will happily erase it, leaving to you the "burden" to restore stuff after the update.
I have an i Pod Touch 4th Gen that has i OS 5 by default.
So you should be able to upgrade to it through i Tunes when it prompts you to update it.
I have an i Pod touch (not mine) connected to my PC (authorized and linked to the same account of the i Pod's owner). Right clicking on the i Pod and selecting "Backup" runs too fast, I don't think it copied the whole 3Gb over.