Yes, as long as the video codec used is MPEG4 based, ie divx or xvid.....
Other video codecs aren't supported.
To test, I just burnt a few divx encoded .avi's to a CD-R and they worked no problem
To quote the video blog at http://blogs.msdn.com/xboxteam/archive/2007/11/30/december-2007-video-playback-faq.aspx:
Xbox 360 supports the following for AVI:
· File Extensions: .avi, .divx
· Containers: AVI
· Video Profiles: MPEG-4 Part 2, Simple & Advanced Simple Profile
· Video Bitrate: 5 Mbps with resolutions of 1280 x 720 at 30fps. See question number 11 for more information.
· Audio Profiles: Dolby® Digital 2 channel and 5.1 channel, MP3
· Audio Max Bitrate: No restrictions. See question number 11 for more information.
Reading through that blog post it says h.264 is supported but you need to change the extension to .avi?
Does renaming .mkv as .avi work? I'd try but I am not at home.