Yes you probably will have to pay for a new phone. To cancel the contract you'll have to pay the line rental for the rest of the contract term (for example, if it was a 12month contract at £20 a month, you'd have to pay the remaining 10 months and maybe an admin fee too).
My first contract phone was through Phones 4 U, and I'll never use them again! (When I did, the insurance didn't cover loss, it only covered theft - and only then if the phone was forcibly taken from your hand. I had to threaten to take them to Trading Standards for mis-selling to get the first month's premium back when I decided I didn't want it - well within the take-back period (they explicitly said insurance would cover lost phone and accidental damage, which it didn't) it may have changed since, but don't beat yourself up for not taking the insurance.) I found their customer service to be appalling, in store, on the phone, and responses from complaints divisions. I found a much much better deal elsewhere, that Phones 4 U couldn't come close to beating - the guy was actually knocked speechless when I told him what I had (and that was 4 years ago, I've since got a better deal from the same company.)
If you do decide to pay off the contract, search around a bit more before you take out a new one - most networks do cross-network minutes now. Don't forget to look online as well as in the shops - some networks have exclusive online deals (although you'll need to pay by direct debit for those) Even if you don't fancy that, look online at as many networks as you can think of. Ask around at work to make sure you haven't forgotten any, and get feedback from customers of those networks. (Even if you're just looking for a new phone, look around first) Good luck!
PS - if you do go into the shop for a new phone/ new contract, DO NOT let them pressure you. Write down all the info they give you and tell them you'll have to think about it. If they say "It's a limited deal! I don't know when it'll close, it could be tomorrow!!" IGNORE them. There are literally hundreds of deals out there - you'll find another almost exactly the same - and what company closes deals without making a huge song and dance of it to get extra business? These guys just want the commision from your sale. One way to keep quieten them is to ask their name and when they're working and say you'll come back and ask for them.) You don't even need to leave it long - 15 minutes, half an hour. Enough time to get out of there and think clearly about what they've told you, what they haven't told you, what you need and what's being offered and make a sensible choice without sales talk distracting you.)
