Welcome to the Apple community.
Yes you are correct the Apple TV 1 could output at 1080p amongst other resolutions and the newer one can only output at 720p.
However don't be too concerned by this since they both are only capable of playing 720p, but the Apple TV 1 can upscale it, whereas the Apple TV 2 just let's the TV upscale it. Indeed the Apple TV can play higher bit rates, so generally speaking I'd expect the Apple TV 2 to produce a better picture under ideal circumstances.
Thank you for your quick reply!
I guess my question then would be if I am going to rent a movie from the iTunes store, would both stream it at 720p or would the Gen 1 stream it at 1080p? I download a mostly HD movies and play them on a Sony KDL52XBR6 that is full 1080p.
My other concern is that the Gen2 does not have any way to store the movie and with cable, the download bit rate can vary widely. I sure don't want a movie to stop every few minutes!
It would be the same rental download on either AppleTV1 or 2 (currently) - up to 720p resolution for HD. AppleTV1 would not be able to decode 1080p in real time, it can't manage to do 720p at 30 fps but will handle 24/25 fps.
AppleTV2's lack of storage is a nuisance if your interet connection is slow as using it for other things tends to flush the download from memory. As a guide on a 3-4 Mbps connection it takes up to 40 mins for an HD to download enough to allow uninterrupted playback. 6-8 Mbps constant speed would give near instant playback. You can rent in itunes and stream on LAN to AppleTV but content is more limited (at least in UK), with some HD titles only on iPad or AppleTV.