According the the official PSP website , the Sony PSP will be be able to play movies in MP4 ( MPEG-4 AVC (H.264)) format using Image Converter 2 (purchased separately). It is known that IC2 can convert AVI, MPG, WMV, MOV, and DivX Avi with audio encoded in MP3. Similar to how IC movie files are transferred to the Clie, users need to transfer the MP4 files to a Memory Stick Duo which the PSP supports.

A Trial version of the Image Converter 2 will be available on Decebemer 14. It is not yet know if this is exactly the same version that the Clie VZ90 is bundled with or an enhanced version to support the PSP screen.

Thanks to Engadget for the tip.