It isn't strange at all, a very normal warning. You received the message that the xp version on the computer IS newer than the original one on the disk because the XP installed on the computer has been updated, therefore it IS newer than what is on the disk. For instance, I have two computers, one is XP and the other Windows 7. If I wanted to "redo" either one of them I would receive that same message because my original XP disk is XP SP1 and now my XP computer also has SP2 and SP 3 installed in addition to all updates since the SP3 install. My Windows 7 computer came with Windows 7, since I purchased the computer SP 1 for Windows 7 has been released and installed along with all other updates released since I purchased the computer. A "redo" as you call it would take the computer back to that original install and remove all additional updates, which would then have to be reinstalled in order to bring it back up to today.
You should not just repair or redo because, based on all you have done on the computer with the various programs you remember running and the rogue programs you ran, a simple repair/redo likely will not work well, you need to fully reformat the hard drive and then install XP using the disk. Then install the hardware drivers and then you would need to update XP via Windows Update to bring it up to today.
You couldn't do a system recovery because a file is corrupted does not mean a file on the disk is corrupted, it means a file ON the computer itself is corrupted and therefore cannot be recovered.
I also would NOT advise that you use MSE as an anti-virus program, it is very much lacking in my opinion. I help at several forums and see a lot of computers running MSE with infections. I would strongly recommend either Avira 2012 Free, which is what I use or Avast Free, both score much, much higher than MSE on independent testing and generally are rated in the top 5 of all programs, paid or free. Another one NOT to use is AVG.



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