OK, I understand now why you start off with that much water...4 lbs of grain in a bag.
From what I've read, steeping extraction is about 40% efficient. Multiply that by 4 lbs and it's equivilant to about 1.6 lbs of DME.
For boiling 3 gals you'll need to up the malt to about 3 lbs to keep it about a 1.040 gravity.
What you need to do with that second pot (that has the malt and hops in it) is to just add the malt and hops, but not the water to the 3 gal wort.
This will start you off with 3 gals and 3 lbs. Boil that for 1 hour (I would do it for 45 mins, but that's me) to extract the bitterness from the hops.
I would boil it for 45 mins and remove it from the heat then add the rest of the malt and steep for 15 mins...strain/remove hops then top off to your final volume.