I faced the same issue at least couple of times. But, but now its stable. I also have Android 2.1 update 1 version on my phone.
I strongly recommend you to back up all your data (Call logs, Messages, Bookmarks, Contacts and Market Apps) to a PC.
After backing up your data try the following.:
Reset the Settings (Settings -> Privacy -> Settings reset). ItsIt's going to restart the phone. Let it restart the phone.
If step 1 doesn't help then do factory reset (Settings -> Factory data reset). ItsIt's going to remove all the data from your phone.
If still no help then use Sony Ericsson Update Service to flash the Stock (Original) ROM into your mobile.
Please format, remove and reinsert the SD Card into your mobile.
You can try the Nathan's solution, but your phone's Hardware should support the latest Android versions (>= Android 2.2) otherwise there is use ofare Custom ROMs.
As far as I know your phone's hardware won't support higher versions of Android. It allows you to flash the custom ROM but you will be able to use very minimal features of that Android.