Don't upgrade to Lion with less than 4gb of RAM, unless the computer isn't able to take at least 4gb. If money is tight, upgrade the RAM and leave yourself at Snow Leopard.
Since Lion is only $30 and RAM is pretty inexpensive at the moment, you very well might be able to do both.
Upgrading RAM on any 21st-Century iMac is easy as pie.
Here's the place to go for fully-illustrated guides, although this is SO easy you could probably figure it out just by looking at the back of the iMac:
Edit: For what it's worth, I have a mid-2007 2.4ghz Core2Duo 20" iMac and Lion is running great on it with 4gb of RAM. My machine is one of the earliest Macs that is able to run Lion.
I have a 2008 MacBook Pro with 2Gb and its pretty laggy running Lion - Activity Monitor says the memory is maxed-out and I get the spinning beachball a lot on Safari. Altogether, not a very Mac-like experience, so I would stick with Snow Leopard unless you can afford 4Gb.
Just waiting for my 4Gb upgrade to arrive.
Just went through the same situation with my 2006 iMac. Technically my memory tops out at 3gigs, but I can get 4 in there if I insist (though the machine won't take full advantage).
After a considerable amount of research, and hearing some horror stories of some folks who dove straight into Lion on older machines, I opted on upgrading memory to 3gig, backing up all my data, then running a clean install of Snow Leopard. I then reinstalled all my stuff, followed with a run of Monolingual (a shareware program that removes unnecessary languages and builds), then ran OnyX (another shareware) to run scripts and check/repair permissions.
Works fantastic. Machine is operating perfectly on 10.6.8 and with the memory upgrade and clean drive its running faster than ever. Definite new breath of life in the machine.
As per memory upgrade, I'd recommend going to Crucial. They're very Mac friendly, customer oriented, and reasonably priced. They have a small program you can download that scans your machine to determine the correct chip required, then brings you stright to an info and ordering page. I managed to get a 2gig chip with shipping for about $25. With the Snow Leopard upgrade total cost was under $60 for resuscitation.