Audio Crackles On Playback

Dear forum users:
System details
Dell Laptop - Inspiron E1505
Genuine Intel CPU: Core Duo Processor T2400 @ 1.83GHz
1GB of Ram
Video: ATI Mobility Radeon X1400 (using Omega 3.8.442 drivers, Dell drivers where outdated)
Soundcard: sold as Soundblaster HD.. but really is a SigmaTell integrated HD
WiFi and Bluetooth
HDD Toshiba 100GB
Running Windows XP SP3 (final release)
System age: 25 months
I've come to you as a last resort. So you see, I have an outdated system that fared pretty well for over two years. Despite low memory, I've been able to play almost all big title games (from HalfLife 2 to BioShock, low details ofcourse) and I've also been able to work with serious engineering software (from AutoCad to SolidEdge and ANSYS modeling). The system has normal lags, but it carries through.
Now the sob story. I was surfing and listening to some mp3's on my iTunes (yeah, it works fine for me, go figure!) and suddently the system starting lagging, the audio starting crackling and poping. I stopped iTunes. Started over another song and the first 5 seconds where ok, but then the lagging became evident (mouse moved very slowly, almost non-responsive) and the audio stuttered and crackled for 10 to 20 seconds, then it seemed to smooth out. I was baffled so I tried closing every program running and left iTunes. Again, to no avail, the crackling and lagging came after 5 to 10 seconds of Audio. I tried different mp3 players. Same result. I tried online audio (aka youtube). Same stuttering. I restarted. Several times. Again, crackling. In all this I noticed that if there were various processes/programs running, the lagging and crackling became worst. I also noticed on my CPU monitor that activity of the CPU spiked to over 70% during the crackling, then came down to the normal 3 or 4%. This, as you might imagine, is very annoying.
I have now spent a good part of 3 weeks trying to solve this issue. Since the first awful night of crackling songs, I've done all of the following:
- Reinstalled all audio and video drivers, codecs, and audio and video related software
- Removed unnecessary software from my system (old games, freeware, etc)
- Scanned several times with different online and offline antivirus programs
- Scanned several times with different malware and ad-aware programs, cleaned everything there was to clean. Still nothing.
- Updated Windows with every single patch known to Bill, even installed SP3 finally
- Created a secondary user account with admin privileges. still same audio problem
- Cleaned my registry several times with various registry fixing software
- Defragmented HDD twice!
- Ran all diagnostic test that Dell includes at startup (from battery tests to full mem tests)
- Updated BIOS from Dell support
- Tried turning off wifi card and bluetooth. to no avail
- Reinstalled latest DirectX software. Still nothing.
So, you see, the plot thickens. I've searched hundreds of similar posts, but I haven't seen one possible solution. What's even worst is I've seen posts where people actually reinstall the whole OS and everything else and the problem persists. I've also seen people adding twice the RAM and still no dice. I mean, why should I need more RAM or a better processor if things where running perfectly fine??
I mean, honestly, the damn thing was working perfectly and then this happens. For no reason?
Can it be a battery issue? Can it be a HDD issue (all diagnostics return OK)? Any help will be greatly appreciated.