Best way to simulate a camera?

Why is there distortion in your video image? raw data off the A/D should be the best quality you're going to get. Connecting the camera to your computer and matlab probably wont be any different, so you'll have to do the same filtering in matlab or the FPGA.

As for solution 3 - this is fine if you are only ever going to simulate, plus it can be a very good way for testing individual algorithms/filters. But it does not overcome problems 1 and 2.

Im guessing you're worried about phantom targets appearing?