Switch 3GS phone to new user and keep contacts

My wife got my brother's old iPhone 3GS from him when he upgraded to the iPhone 4 over a year ago.  The person at AT&T transferred my wife's contacts from her old phone to the 3GS phone.  She can't buy any apps without using my brother's ID so she hasn't purchased anything yet.
She wants to clear the phone but still keep all of her contacts.  I was wondering what steps she would need to follow to do it.
We did go to the Apple store but didnt our laptop with us to try and work through it there and the directions that we got were a bit confusing after we got home.
Any help would be welcomed?
Also, would it be beneficial to upgrade the iOS to the latest version as well since the phone is currently running v3.1.3?
Thank you.

Here's what I would recommend:
Before I begin, does she have her own ID? If she does, then continue reading. If not, go to http://appleid.apple.com and make one for her.
Yes, upgrading to iOS 5 would be very beneficial. Have her upgrade to iOS 5, and then set up "iCloud." This will allow her to back up her contacts to the cloud. Then, she can wipe the phone, and once she re-enables iCloud after the restore, "Contacts" should be on and then appear on her phone.

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