I think you can only upgrade the OS in the SD card to Diablo if the flash OS is also Diablo.

To upgrade, I think you would do:
1. Boot from SD, backup.
2. Boot from flash, backup.
3. Flash new OS to internal flash.
4. Clone the SD. Make dual-bootable (download fanoush's init_flasher)
5. Boot from the SD. Update the OS. Then restore the apps to the SD from the saved backup. ( check the repositories, get rid unwanted ones,...)

Please read more under OS2008 section.