Substantial update of an arXiv paper
You cannot completely withdraw a paper from arXiv; instead, the system can add a retraction notice on it. So, if you follow option #1, you'll end up with 1. an old paper, 2. with a retraction notice, 3. a new paper. It's a bit of a mess…

I would suggest the following:


Consider your much-improved version as a new article: get it published, upload it on arXiv. In the arXiv version, you may refer to the older arXiv paper (“This article is based on the same results as …, but the presentation of results and the whole discuss have been reworked substantially”). Put it either in the introduction or, if you don't want to disrupt the flow of text, as a footnote or “banner” before the introduction.
Most importantly: make a update to your old paper, for a version that links to the new paper. That way, you make it completely clear that a improved discussion is available.


This addressed the only issues I see, namely making sure that people can find your work, and that you're not suspected of duplicate publication (which, on an open platform like arXiv, doesn't make much sense anyway…).