I'm currently using that same machine you have as an (interim) HTPC machine.
Swapped Win 7 64 bit to 32 bit (due to the low memory), upgraded to the latest drivers and Flash 10.1
Handles 1080p MKV's just fine, as well as 720P YouTube (1080 drops some frames on fast movement). The only problem is that Hulu apparently isn't taking advantage of the new Flash beta, and still seems to run 100% on the CPU rather than offloading to the GPU like YouTube now does. So for Hulu it can only handle the standard def video. 480P Hulu is fine windowed, but scaled to 720p or 1080p, it drops frames really bad.