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Yes, they can update the firmware to unlock 720p. I've always said it. And yes, they can go back to 480p in menus without problem. The GPU should have the needed pixel fillrate and the GPU has access to the main GDDR3 RAM, so it could use it as framebuffer... that in case the eDRAM is just 3MB RAM like the GC, which most people have assumed it is without even looking a die shot or anything.

But this is all rumors, remember that. And just for the records, remember that at first Xbox 360 didn't support 1080p and then was added with a firmware update.