I have no idea why they dropped 480p for DVDs... The Conexant chip that handles the output can do it for games, so there's no reason it couldn't do it for DVDs.
And yes, I'd pick up the HD pack if you have an HDTV. It's only 20$... 480p will look better than 480i without a doubt, and you'll also be able to use higher resolutions when games support it. (720p is a possibility) It also adds optical output for DD 5.1 in games and DVDs if you have a HT setup.
edit--- I found the answer...

Taken from Anand's article:
This isn't because of a hardware limitation rather that it does not support Macrovision in 480p mode.
Makes sense, the MPAA woud've sued them if they'd enabled playback without Macrovision.