I have exactly the same issue my friend. I have a Mid 2007 24" iMac and everything was well a few weeks ago. I installed Mountain Lion and after about 2 weeks of everything running smoothly, one day i turned it on and within 10 minutes the GPU diode temperature went to 120C and the GPU temperature at 100C.
I did everything you can imagine. I open the iMac myself (i had done that in the past too), took off the GPU, GPU diode and heatsink, i applied new thermal paste, but nothing really changed.
I ran the Apple Hardware Test and it gave the error 4SNS / 1 / 40000000: TGOH.
I read that it is the temperature sensor of the graphics card connected to the logic board (not the internal sensor).
I went back to Snow Leopard, did all the updates and now although the problem still exists, iStat shows 20C less than before when idle or doing simple tasks. GPU at 80C, diode at 92-96 and heatsink at 86C. If i open a youtube video, especially on HD, or if i try to play DIablo 3 or even Warcraft 3 the temperatures go crazy again, like with Mountain Lion.
Did you also install Mountain Lion before this happened? I don't think it's a random fact that we both have the same issue on the same model...
In a few days i'll go to a premium reseller, which is about to acquire Apple Authorized Service. If it is indeed just a problem of the sensor, i hope i won't have to replace the whole gpu. The iMac itself isn't worth that much now...