What is the difference between vmalloc and kmalloc?

Short answer: download Linux Device Drivers and read the chapter on memory management.

Seriously, there are a lot of subtle issues related to kernel memory management that you need to understand - I spend a lot of my time debugging problems with it.

vmalloc() is very rarely used, because the kernel rarely uses virtual memory. kmalloc() is what is typically used, but you have to know what the consequences of the different flags are and you need a strategy for dealing with what happens when it fails - particularly if you're in an interrupt handler, like you suggested.

You only need to worry about using physically contiguous memory if the buffer will be accessed by a DMA device on a physically addressed bus (like PCI). The trouble is that many system calls have no way to know whether their buffer will eventually be passed to a DMA device: once you pass the buffer to another kernel subsystem, you really cannot know where it is going to go. Even if the kernel does not use the buffer for DMA today, a future development might do so.

vmalloc is often slower than kmalloc, because it may have to remap the buffer space into a virtually contiguous range. kmalloc never remaps, though if not called with GFP_ATOMIC kmalloc can block.

kmalloc is limited in the size of buffer it can provide: 128 KBytes^*). If you need a really big buffer, you have to use vmalloc or some other mechanism like reserving high memory at boot.

^*)This was true of earlier kernels. On recent kernels (I tested this on 2.6.33.2), max size of a single kmalloc is up to 4 MB! (I wrote a fairly detailed post on this.) — kaiwan

For a system call you don't need to pass GFP_ATOMIC to kmalloc(), you can use GFP_KERNEL. You're not an interrupt handler: the application code enters the kernel context by means of a trap, it is not an interrupt.