Well I may not be able to help you out entirely but this is what I did. I bought an external USB 2.0 hard drive enclosure a while ago. Before I got my 360 I saw Llamas tutorial on adding an external HDD. I thought cool, I now have a use for my enclosure. I had a spare 80gb HD laying around so I formated that, dumped my MP3's on it and went to town.
I played around with that for a while and remembered reading about Windows Media Connect. I didnt have SP2 installed as Im just running XP Pro. After I got that all sorted out, I now didnt have the need for the external HD anymore. Which was kind of a pain because I didnt want to have to turn the external HD on all the time and didnt want to leave it running all the time either. There arent really arent any differences between the two, other than convenience. While scrolling through some of my music I noticed the the M3U files (playlist files) showed up. Although I didnt try to play them, they were there. Im somewhat disappointed in the media player on the 360. There arent many features, like random or shuffle. I think I saw somewhere about people running apps like winamp or mediaplayer on the 360 but cant confirm this. If thats the case I would use that over the 360's media player.
As far as video goes, I havent even tried yet. Mainly because I dont have need. I have read that people are getting good results with Transcode360. Although I think the use of this program is for playing full length movies.
Sorry I couldnt help out more, but this is what I've had experience with.