When you display a 720p game on a 1080p display one of several things is going on.
1. The 1080p display switches to 720p mode and the signal is stretched to fill the display
2. The 1080p display upscales the 720p signal to 1080p, depending on the display features
3. Your Xbox 360 upscales the 720p signal to 1080p
4. The game engine code upscales the 720p signal to 1080p mode
Upscaling means approximating more pixels through interpolation. It is not the same as displaying a lower res signal at full screen on a higher res display.
The easiest way to differentiate between the two is to watch a DVD on an Xbox with an HDMI connection, and then without. The former upscales the 480p signal to 1080p, while the latter produces a 480p signal stretched, not interpolated/upscaled to fill your 1080p display.
But yes, more vertical lines of resolution, including with signals using non-square pixels, produce a smoother image as in greatly reduced pixel stepping ("jaggies").