Do you know how DivX works?
It's basically the same thing, it's just a method for compressing various formats into a single file, and using the proper decoder you just unpack it on-the-fly and it plays whatever you select it to play. And just like DivX you can achieve DVD -like menus and interactivity, good news (no i didn't save a bunch of my money on car insurance by swithing to Geico) IT'S FREE!!! Think it's open source too..not sure yet...
Check out
http://www.matroska.org/ for more info.
N.B. DivX uses the .avi video and various audio (AC3 mp3, mp3, etc) .mpeg variants in its codec. Tha's why some movies in .avi are also distrubuted with the DivX player.
(P.S. as you might have figured out, i'm a big fan of DivX
)