Think of it like this: You have a movie that someone ripped from DVD and compressed it to, lets say, 480i. Well, it will not magically upgrade itself to 1080i/p, unfortunately. Having the HD connection is good, but it's only as good as the video format/quality that pipes through it. I believe that SD goes up to 480i, ED is 480p, and HD starts at 720i. Also, Blu-Ray disks are VERY large in size to download (around 30GB per film), so I don't know how good of quality you could get and not kill the HDD... Just to clear it up a bit.
Now, I must say that I hook up my POS laptop to my 42" LCD TV (1080i), and movies at DVD quality look very nice on it- And that's using an S-Video cable!
Also, sounds like a nice set up. I'm thinking of getting a surround sound system later this year (we're moving in like a month, so we can't afford it now).