Need to be schooled on surround sound systems

Give us a price range and we could suggest some systems. We would also need to know how big you want them, given your room is only about 12x12 I'm gonna bet smaller would work fine. Another aspect of having a 12x12 room is that you probably have the couch against the back wall which is bad for 7.1, the back 2 speakers would be too close to your ears. Any receiver that has HDMI is likely to also have optical so that is not much of a concern.

response to edit
It would be best to have everything run thru the receiver then only have 1 HDMI cable running to the tv for video. If you were to set it up like you said then you would not have an HDMI cable running to the receiver, just an potical cable. I'm not sure but i don't think any tvs have HDMI out.

Room like that, I would do a 5.1. You can add 2 more surrounds later if needed. You want all inputs feeding through receiver if you want best audio possible. Any 1080p source will be passed to TV as is. If any of your sources do not do 1080p, or you plan to include a lower Res source like a Wii, get an upconverting AVR. Though gotta say, good chips are costly. I also suggest making sure you get an HDMI 1.4 AVR - they are just starting to come out.

I would highly suggest that you try to find a layout that is more conducive to surround sound. If you could supply an overall picture of the room that would be great!

Given your low budget, small space and non-optimal layout I would suggest you stick with a stereo setup for now. Get a receiver like the Onkyo 308 from amazon for 229 and a set of Dayton B652 from the same place. The Daytons are rather new on the block and not really discussed on this forum yet but from what I've heard they one of the most bang for your buck speakers that exist. In the future I would suggest a subwoofer, Center channel and finally the surrounds. A subwoofer can shake the house if you turn it up but it when tuned properly they can produce sound frequencies that normal speakers cannot, generally below 60-80hz. Low frequencies are important for explosions, Bass Guitars, Drum Sets. Basically they add more depth to pretty much anything you listen to. That is just my opinion, there are different speakers and receivers that would fit your needs. Respectable receiver brands also include Denon, Yamaha, Pioneer, Specific models of Sony and of course Onkyo. Any A/V cable should be bought from monoprice.com, A $6 HDMI cable will perform EXACTLY the same as a $30 monster cable. A little lesson in speaker wires, The largest factor in speaker wire performance is wire gauge, 16 is generally ok, 14 is good for anything except the longest lengths of wire. If you can rearrange the room then I would suggest you bump up your budget then others can suggest a suitable set of speakers to jump straight into 5.1.

Respectable speaker brands would include:
Acoustic Research
Aperion
Ascend
Athena (Brand discontinued by Klipsch therefore RARE)(I personally own a 5.0 set of LS series speakers)
AV123 (the owner was involved in a charity scam, still decent speakers imho)
Axiom
B&W
BIC (good sub: HC-100, F-12)
Boston Acoustics
Canton
Dayton
Definitive Technologies
Elemental
Emotiva
EMP
Energy
Fluance (Really cheap with good reviews, they have an eBay store)
HSU (known for subs)
HTD
Infinity
Jamo
JBL
KEF
KLH
Klipsch
Mirage
Monitor
Orb Audio
Paradigm
Polk
PSB
RBH
Streem
SVS
Swan
Totem
Tweak City Audio
Yambeka (like Fluance)

Jamo 5.1 for $200 shipped http://www.vanns.com/shop/servlet/it..._c=site_search