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Yes you need to reformat in the Droid and when you boot into recovery there is an option.... I can't remember the name of it. I will boot into recovery and find out and post it for you.
When in recovery go to install zip from SD card and when your in there its like select or something..... and then scroll through and select the file. Also you might need to install a custom rom. Do you know if your using clockwork mod?
Ok I'm guessing you need a new rom so we can see if the wifi will work....... I use ultimate Droid 1 but I've used bugless beast before and its good. Also I'm not sure why it wont let you up date. It might be that the person you got it from is running a very strict rom or they don't have clockwork mod or any number of problems or things they could have done. Did you format your SD card through the Droid? I'm about to start school so my responses will be shorter and not very fast.