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Aside from the legalities of XBMC as a difference between it and MCE, what is the functional difference between the 2 (I dont mean to reduce the importance of the law)? What can MCE do that XBMC can't?

Is there a list of supported functions and files?

Any screen shots?

check the manuals..

Major benefits of MCE:

Web browsing
DVD ripping
CD ripping
Samba server
Possibility of expansion (can play stuff from a mythtv backend if you know what you're doing - also could utilise a TV card)

Theres probably more, but I cant think right now ;p

Old post but as I'm looking for a good home media center as well I thought I'd update the list a bit.

XBMC (as of recent builds)
Uses Mplayer so supports pretty much every format MythTV does
Plays CD/DVDs/Karoake (plus Xbox games)

And now there are a few things ShallaX mentioned that it can address.
Major benefits of MCE:

Web browsing (Nice app called LinksBox based on Links can do that and is being considered for inclusion in XBMC)
DVD ripping (not native to XBMC but there are apps that can do it for Xbox)
CD ripping (XBMC can do this in a number of formats and uses the LAME encoder or a couple others)
Samba server (Not positive but I think it can act as a server, accessible from FTP otherwise)
Possibility of expansion (can play stuff from a mythtv backend if you know what you're doing - also could utilise a TV card) {Can play from MythTV backend, SMB shares from Windows or Linux, Shoutcast streams, Apple movie trailers, not to mention scripts for YouTube and other sites, and recently someone added a HOWTO on getting TV streamed to XBMC)

As with all decisions regarding computers and technology you have to decide what is right for you. Linux is powerful and there is a lot that it can do that XBMC can't and the Xbox otherwise couldn't, but there is also a bit of a learning curve and setup time that makes apps like XBMC look nicer. You be the judge of what works best for you.

Again, none of your solutions are viable because they are all illegal.

Very true, and sadly it seems that most developing groups have headed over to the 360 so its uncertain whether the OpenXDK will ever fully develop or not. So for the legal method Linux on the Xbox (and I heartily recommend Gentoox) is the best bet for interfacing with MythTV among other things.