That's a great question and really goes to the heart of YouTube's business model, YouTube's API and WP7 Integration.
Short answer: To a limited extend it could be possible to play low-quality videos in WP7.
The first question you should ask yourself is: "What is Google?" The answer is "An Ad serving company". The overwhelming majority of Google & YouTube's revenue stream comes exclusively from advertisements. If you were to take YouTube's content and serve it on your own website/app without any YouTube branding or ads, that would works against their financial business model.
The second question you should ask yourself is: "So how is iPhone showing YouTube videos? And WP7? Or YouTube website itself for that matter?". This goes into the heart of YouTube's media delivery system. YouTube publicly exposes multiple formats from their website. For example format #1 is H263, Format #6 is MPEG and Format #5 is the SWF/FLV content. You can read more about YouTube Formats in their official documentation.
And now, to answer your question. YouTube API only exposes thumbnail size videos for unauthorized 3rd parties and those could potentially be showed in WP7 in-app. However the video quality will be terrible if scaled up for more than 1/4 of the WP7 screen resolution.
I suggest you read through the GData YouTube developer guide for information on the API. I'll do a quick run-through of how to get to those public videos. Personally, I haven't been successful in getting these 3GP videos to work on WP7.
Open up the GData feed for top rated videos: http://gdata.youtube.com/feeds/api/standardfeeds/top_rated
from the < entry /> element find the < id /> element which should have a link to single video GData feed. I picked up this one: http://gdata.youtube.com/feeds/api/videos/dMH0bHeiRNg
find the < media:content /> elements with yt:format attributes.
< media:content url='http://www.youtube.com/v/dMH0bHeiRNg?f=videos&app=youtube_gdata' type='application/x-shockwave-flash' medium='video' isDefault='true' expression='full' duration='360' yt:format='5'/>
< media:content url='rtsp://v5.cache7.c.youtube.com/CiILENy73wIaGQnYRKJ3bPTBdBMYDSANFEgGUgZ2aWRlb3MM/0/0/0/video.3gp' type='video/3gpp' medium='video' expression='full' duration='360' yt:format='1'/>
< media:content url='rtsp://v3.cache8.c.youtube.com/CiILENy73wIaGQnYRKJ3bPTBdBMYESARFEgGUgZ2aWRlb3MM/0/0/0/video.3gp' type='video/3gpp' medium='video' expression='full' duration='360' yt:format='6'/>
Open up "VLC Player" with format #6 URL and you should see the RTSP stream player.
** This whole post should be considered "As far as I know". This is all knowledge I gleamed from official YouTube documentation and forums.
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