I have the following settings in my squid.conf file relating to the memory usage:

cache_mem 200 MB
maximum_object_size_in_memory 512 KB

cache_replacement_policy heap GDSF
memory_replacement_policy heap GDSF
cache_dir diskd /var/spool/squid 200 16 256 <----

200kb? thats less than 1 mb dude, add a couple zeros to that.

1024=1MB  so, adjust according to your environment, IE disk space.
From the man pages:

cache_dir diskd Directory-Name Mbytes L1 L2 [options] [Q1=n] [Q2=n]

So, no - "200 16 256" means 200 MB storage, 16 L1 entries and 256 L2 entries.

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