About the streaming part... The harddrive of the ATV doesn't matter much - as long as your Mac is running. I've got a 40 GB ATV and a 800 GB iTunes library. I've set it to sync automatically. I'm never entirely sure what's really on the ATV and what's streaming-only, but my iMac, which hosts my iTunes library, is always on, so it really doesn't matter.
But, as has been said: It only works with files that are actually in the iTunes library. There are workarounds, but they certainly void the warranty and seem too much hassle to me. Transcoding video takes some time, of course, but it's worth it. iTunes is really becoming a very good "jukebox" software for all things music AND video.