I haven't had to do any conversion of the authorized downloads to a different format - they arrive as mp4s. You can add them just like any other file, or even just click on the mp4 and it may launch your itunes (depends on how your options are set).
My only problem with the downloading the full library is getting them all on my system; I've got an ongoing dialog going on with SNM there, so hopefully we'll eventually get a solution (and no, it has nothing to do with my connection speed, similarlly sized video files are loading just fine - but the helpdesk is doing it's best to diagnose what's going on). That said, the files that I've downloaded have been of high quality. They work very well with my itunes and ipod, whether nano or touch; it's been really nice to have them along when traveling! Am looking forward to being able to use the full library.