No, I wouldn't remove other stuff and reload iMovie. Maybe reloading iMovie will fix the problem, but I'm not sure. You do have iM09 which is the exact version I have which has PiP. If you do reload iMovie, drag the 'old' version to trash and empty the trash.
I would first do a simple test. Open iMovie from a closed state, and review the preference to see if it is still set as you left it. If not, then use Disk Utility to fix Permissions and then open iMovie, change a preference, close iMovie and then reopen it to verify the preference is sticking.
What some people do is remove the preference file for the application that is misbehaving. That would be com.apple.iMovie8.plist which is found in your personal "Library/Preferences" folder. You can just drag and drop it into the trash.
I just did some experimenting and found the shortest clip I could use as the PiP was five frames. Anything less and the clip slides back to the Event pane. If you try a clip longer than that the receiving clip already in the project, the longer clip will be truncated to the same length.
Just to be clear, I've attached two images. The first is the check marked item in the iMovie preferences as it should appear. The second is what my 'insert' selections available are when dragging a clip from an event
on top of the clip already in the project. And yes, it does sound like you are doing it properly.