It has to be MPEG-2, I believe (like a DVD). But it shouldn't matter whether it's a DVD or file on your drive.
You have to use specific software. MediaMatics DVDExpress is the most commonly used, but you may have to use a specific version of it. The version of DVDExpress that shipped with some IBM DVD drives, and that was often distributed along with machines that had a DEVA card is available here:http://thinkpads.kiff.ca/files/DVDExpress-27L2581.ISO
After installing that version, you'll want to go to the driver matrix and find the upgrade that is available for download from the Lenovo/IBM site for the 770 series. It is a full upgrade that will replace the version above, but you need the one above to be installed before you can install the upgrade.
Some people have been able to get Windows Media Player to use the acceleration features of the DEVA card. Especially under Windows 2000. And the built-in rudimentary dvdplay software that came with Win2000 seems to take advantage of it as well. It is not clear to me if the version of Windows Media Player (WMP) that ships with XP will take advantage of it or not. I strongly doubt that the latest versions of WMP do.
Some related info is available here:DVD Software
On my machines, I found that DVDExpress was the best option. And then you could install WMP for other things if desired.