The problem is not the picture size, but highly compressed bitrate (amount of data for a frame) with large picture size. Encode Xvid or MP4 with lower bitrates and you can achieve the same large image size.
MPEG2 - more data to read (disk, network etc), but easier to decode (less CPU + memory).
Xvid/MP4 - less data to read (better compression), but harder to decode (more CPU + memory).
Think of picture size as a projector screen, you may think larger is better (more pixels to display). But then bitrate is the picture quality (amount of detail) - higher is better (high detail) but it takes more space to store and process, lower it too much ant it looses detail (little blocks); that's the quality ("resolution") of the picture on the projector screen.
Personally, I prefer to encode at lower resolutions (even as low as 640x360) and bump up the bitrate to fill-in for lack in resolution. Let XBMC4Xbox handle the scaling, with good picture quality you will not see much of a difference. You will see a difference in file size though and it'll require less CPU/memory to playback.
I'd recommend Handbrake (
http://handbrake.fr/) you can very easily push through DVD files or other files (like larger MP4) and convert them into smaller MP4s (I said so many times I'll write a post on that, I just won't promise anymore, but it's dead simple). If you want really good quality, use double pass conversion (it goes through the data to decide where to allocate more data to high speed transition frames or detailed frames for a better overall result).
) . its in a badly and beaten up state but works nevertheless. thing is the box have a screaaamig old version of XBMC, a T3CH build from 2008 (that idiot never updates) and not sure which version i have to update and how... i mean... if its safe to update from that old version. (its a softmodded box, so i don't want to screw it).
) not sure if the HD version of PM3 can be used.
