answers: downloaded a 2 minute trailer in high definition format (.mov) , converted to h.264 HD format, transferred to my mba's itunes 8.0 movie folder AND tried to sync to my ATV movies folder. Here's a screen shot:
If you notice, the ATV icon on the device source has an exclamation point beside it, which means NO, YOU CAN'T output anything beyond 720 on the ATV (software version 2.1). although ATV supports up to 1080i displays. I tried all sorts of HD formats using h.264 but ATV refuses to accept it.
For now, the maximum and acceptable format is 1280 x 720 in h.264 or mp4 material. So, what's the point of being able to support 1080 HD displays while limiting material for output at 720? My guess is Apple is working on higher than 720p material for the next generation ATV.
I am still downloading some HD TV (free episode) on my mba's itunes 8.0. Will post comments after I'm done.