My guess is that the harddrive is shot. Difficult to tell from across the 'Net.
Do you still here the knocking sound? Does it make any other noises when it lags?
I'd say swap the drive out to another system and see wether it can use it OK. If not, send it in for warranty.
While you're at it: see wether all cables are attached correctly. I've destroyed 2 drives by using a faulty power-splitter, so check the wiring.
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