Using Time Machine within iPhoto to restore an individual picture won't restore the edits. You're restoring the master file, not the copy that incorporates the edits.
If you use Time Machine to restore the entire drive, the entire iPhoto Library is restored, edit copies and masters.
While you can use Time Machine to restore a system drive, I find using a clone created with SuperDuper (or Carbon Copy Cloner) to be faster and more robust.
If your goal is to install a fresh copy of the operating system you can do so by installing Mountain Lion over the existing copy. It will leave your user files in place. (Make sure you have a good backup, or three, before you try this.)
If this is unsatisfactory, you can install the OS on a freshly formatted disk, then bring your user files over from a clone copy using Migration Assistant. See Apple Knowledgebase: How to use Migration Assistant to transfer files from another Mac