I've wondered about the best way to do this as well. I refuse to pay for a service that makes me watch commercials (cable/sat TV). IMHO advertisers should be paying cable companies to give away cable access to people who want it, or there should not be commercials if I'm paying. Why do I need to pay to be advertised to? I'm sure it's more complex, but I just don't care.
My setup has evolved over time. I have a 30 Mbps Internet connection, a 55" LED LG mounted to the wall in my living room, and a mid-line BD/surround system. The evolving part is the media source of course. I started with a small tower with Windows 7 running on it. It let me play my Windows-based games on my big screen and I could stream Netflix, Hulu, iTunes, CDs, DVDs, Blu-Ray, and my questionably acquired collection of movies and TV series.
Disclaimer: I know from reading this site frequently that most people here don't like Apple. The disclaimer part is that I just don't care. My views are based on my experience.
Eventually I decided it was taking up too much space, making too much noise, and taking up too much electricity (didn't want to shut it down because takes a while to boot). Over the last couple years I've picked up an iPhone and an iPad, so as a natural progression I decided to try the Apple TV. It has some nice features such as being 1080p, having AirPlay (lets me stream music and pictures from my iDevices, and lets me mirror the screen on my iPad, some games work with it too), and a superb Netflix interface (much better than most App-enabled media appliances). I've picked up a few TV series and a few movies and they play beautiful video and sound. Since most people seem to have iDevices nowadays, it's nice for friend and family that come over to be able to share pictures and videos and such from their phones on the TV.
The problem with Apple TV is that it's the usually Apple-walled-garden situation. You're limited to the services they provide (for now). I suspect they will open the Apple TV up for app dev soon (like they did for the iPhone when the Appe Store was announced) based on the direction the interface is heading. Once that happens it may be a solve-all solution for my needs. But until then, there is one major problem with it... there's no way to play my video collection.
To fix this, eventually I picked up a Boxee from Best Buy (made by D-Link... not my favorite brand). So far it has been a fantastic solution. It streams my video collection on my LAN flawlessly, streams Netflix (interface is not as polished as Apple's), Pandora, Vudu (decent service), Hulu, and many others. There's an app repository that you can get quite a few apps from, and the ability to add custom repos if you'd like. The remote is not a simple and beautifully made sliver of aluminum like the Apple TV remote, but it's far more functional. It has a full QWERTY keyboard on the back, it's not directional (works in any orientation, so not IR I guess), and the front is a simple interface. The Boxee also support AirPlay for audio and video. I haven't had luck with doing any screen mirroring.
I've only just recently discovered the Vudu service on it. It's owned by Walmart and it's pretty nifty. I don't want to be an advertisement for it but if you go the Boxee route you should definitely check out Vudu.
Over all the Boxee does 99% of what I want and maybe everything that you would want. You can even add an antenna attachment so you can stream local broadcast channels. The Apple TV is nicer in design (smaller, sleeker, cheaper), interface, remote (iDevices can be remotes too), and overall polish. Once they start having apps for it and stuff like Oplayer and Hulu show up on it, I don't think I'll need the Boxee anymore.
I've also considered the Roku, but I haven't had a reason to look at it since I got the Boxee.