If I copy an iso image file of a movie DVD onto the HD, can XBMC play the movie?

Yes

EDIT: You don't even need to copy it over if you don't want, it will stream an iso fine over the network.

Yes, but if any of the any of the main movie is on the remaining 400mb of space on a dvd5 the xbox will not read it due to the FATX file size limitation of 4gb.

It would be best to unpack the iso and have just the main folder then play the dvd by pressing white the click play.

XBMC is pretty awesome. I hate burning (had no CD/DVDs anyway) and had no software to mount the image, but XBMC just played the .bin/.cue file streaming over the network with no trouble at all.