Nope, not everything iTunes can play can be played on Apple TV. The easiest and fastest way to get this movie to play is to drop it on iSquint -
http://www.isquint.com - and let it produce a compatible file. Your .mpg file probably is an MPEG-1 movie file. AFAIK, only MPEG-4 files can be played out of the box (without hacks) on the Apple TV.