can you not just either convert your vids or play them through itunes directly?
could do that but all my vids are on a centrally hardwired NAS throughout home. Converting via handbrake etc would create more storage issues/time/hassle etc.
I have some small bitrate avi some 40gb bluray rips with full dig audio. XBMC can play most of them (high bit rate stuff choppy) and down conversion to DTS sound.
Was using an old WDTVlive that played it all and tried the ATV2/XBMC route and found that it cant keep up with the hidef rips but good for everything else.
Probably will get a newer WDTV to replace the ATV eventually...or tinker more with XBMC.