To be able to create a hierarchical content structure within the
library it is necessary to be able to create folders within
folders. Is this possible or what is the best work around?
See new app Folderize on AppExchange.
From the overview: "Folderize provides the missing folder structure for Salesforce Content Libraries. Create a hierarchy of folders like in a file system; then link documents from existing libraries to one or more subfolders."
The answer depends on the type of content you want to put in your folders...
Code. Files representing code on the Salesforce.com platform are represented in a mostly flat, folderless structure. In order to represent them on your local disc for development and storage in source control, there is a basic folder structure to categorise, Apex code, Visualforce pages, Object definitions etc. each in its own subfolder. However, while its a much requested enhancement, you cannot currently split your Apex code into sub-folders, the best you can do is using prefixing of the class names. Beyond that, you could use Packages to further scope and contain your code (using a namespace prefix), however that is in most cases a bit to heavy weight.
Documents. As in images, written documents, pdf's, csv files, general end user files etc. These can be stored in a growing number of ways in Salesforce, Attachments, Chatter Files, Content Workspace and via the Document object. This option does permit the organisation of Document records (which represent your files) in a single depth Folder structure only, no sub-folders are permitted. Note as per the documentation you can also use them to contain other Salesforce components, such as Email Templates.