Apologies to livingfortoday, but here's how I see iTV:
1. Start with a video iPod.
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2. Remove the screen (your TV is the display)
3. Remove the click wheel (you are going to control it with a remote)
4. Remove the battery (it's going to stay put, next to your TV.
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5. Build in everything you find on the universal iPod dock (an IR receiver for remote control, various A/V ports, power connector, USB connector.) And for Pete's sake, include the Apple remove and various cables to go with the various ports.
At this point you've got a video iPod that you leave permanently docked, connected to your TV. You control it with the Apple remote, and it plays content to your TV, Stereo, etc.
To get content on to the device, you could plug a USB cable from the iTV to your computer, and it would sync with iTunes. But of course:
6. Add a wireless adapter. The iTV uses this to auto-sync with all nearby macs. As soon as a new movie, TV show, song or whatever is available on a Mac, it will start to sync over to the iTV.
Hopefully they'll also allow video content to start playing before it is fully downloaded. That is, when you buy a movie in iTunes, you can start watching it (either on the Mac or the iTV) before it is fully downloaded.
Back to the OP's question, now:
In my scheme, the hardware to decode video is on the iTV, just like it is on a video iPod. And just like the video iPod, I think we can expect some limitations on this hardware. Obviously power is no longer a limitation, but cost, and to some degree size is (Apple will want this thing small and sleek). Apple will target the decoder to the content they expect to deliver. Currently that is 640x480, but I'm guessing the decoder will be capable of at least 720p to allow future expansion on Apple's part. And Apple is taking a real risk if they don't plan to support 1080p. However, you might have to wait for a firmware update before that capability is unlocked.
Conclusion: will it play "mpeg4 or h.264 with a VERY high bit rate"? Answer: Initially, maybe. Eventually, probably. Worst case, you'll have to buy G2 iTv.