Well I'll be darned. This is actually a (modified) Remote Desktop connection between the Xbox and the Media Center PC. Modified, in that a "separate channel is used for streaming video and audio".

So basically, the disc that goes in the Xbox is the Remote Desktop client, and the Media Center UI and apps are all running in a restricted user account on the Media Center PC - you can see the account with the XP administration tools.

This all seems like a reasonably elegant solution to me, although you'll want to have lots of memory and a fast ethernet connection to make it perform well.