Damp Basement = Buckling Hardwood??

Severe water damage necessitates replacing basement bathroom. When I pulled up the old flooring I found totally decayed plywood and floor joists. Beneath that, mud & clay. How do I go about repairing such extensive damage? Half of the basement has a concrete slab and the other half has a plywood floor. I assume that beneath that flooring there is nothing but dirt. Can this be repaired using only lumber? If so, how do I tie it in with the existing flooring without any visible solid wood available? How important is it to get the decayed wood removed? Will it just keep rotting or will it stop once it dries out? Should I have concrete poured instead?

I have just finished framing my basement walls with 2x4s with a 1 inch gap against the concrete wall. Also, i stay in a townhouse and therefore I have 2 exterior facing walls and rest and all interior. In the past 2.5 years that i have stayed in this house the walls have been pretty much dry. Have a couple of questions about the insulation: 1. Do i need to insulate the interior walls? 2. If yes, then what kind of insulation do i need to use? Is it the same for exterior and interior walls? 3. Do i need to use vapor barrier ? And what kind? thanks