I think fuzzy has pretty much nailed this one for you.
I wouldn't bother with blu ray unless you have a 40"+ Full HD 1080p TV.
It looks nice, but cost vs nice to me isn't worth it unless you have like a 50" TV.
if I select it through the 360 menu but when I set the 360 to auto select it ends up 768p.....
I would have thought this is correct, since a 1080i TV would not be able to display 1080p, but can display 720p @ 1080i. Because of the fields it's pretty much the same picture quality anyway, just depends on how your TV will handle it. I don't have a 360 but I thought that it's HD was 1080i?
And yes blu ray plays do upscale to 1080p - but you will need a 1080p TV to do this first. So if you play blu ray on your TV it will only play 720p or 1080i anyway. Like you say, it looks nice (when watching it on TV - noting that HDTV station are only 1080i or 720p depending, not 1080p) but it's not hundreds of dollars worth of difference, to me anyway.
Blu ray is great for home theatres, and I think yes it will take over from DVD... but not long before we all have our TVs plugged to the net and get our TV/movies that way from anywhere in the world, in which case having something as silly as a physical disc that will get scratched, lost, etc will be just crazy
. (I reckon that will be 6-7 years before it's standard).