The "best" setting for HD on your Xbox is the one that matches your TV's native resolution. If the TV shows 720p, set the Xbox to 720p. My TV is 1080i natively (yeah, it's old in HD terms) so I set my Xbox to 1080i output. If you're lucky or rich and your set supports 1080p, set the console to match.
Setting the console to a higher resolution than the TV just makes the TV's scaler work harder. (And may be a cause of controller lag observed by some people, though I'm not technically adept enough to prove or disprove it.)
-- Steve