"The Xbox 360 console supports AVI files with DivX video or XviD video directly (that is, you can play them without any special processes in between from DVD, USB, WiFi etc.) including High-Definition material. As for audio, the console supports decoding stereo MP3 audio and stereo or multi-channel AC3 (Dolby Digital) audio inside the AVI container. This level of support means that the majority of all AVI files you will find around the Internet will work with the Xbox 360 console (assuming you get the Fall 2007 update)."
Link for playing from stick
I am sure you have at least 07 dash/media update, other than that you just need to have your memory stick formated for FAT32 so it will recognize.
It will not have to be on-line if all updates are current. The last media update, now saves the update under the GT that you get it under, so just make sure that profile is selected and it should work just fine. I have a banned console but my updates were already there, so I just hit my gamertag and even though it won't connect me it still allows me to play movies.