I am not sure if I read your post correctly, but you may be confusing/combining two seperate issues.
First, to upgrade the iOS on your AppleTV, plug it in, scroll all the way over to the right in the menu and (I think) choose system or maintenaince to upgrade the iOS for the AppleTV.
Second, when you were refering to the USB drive, I think you may have talking about the software offered by Firecore:http://firecore.com/atvflash?products_id=27
This allows you to hack the AppleTV and add Boxee, XMBC and a few others. Most of these are installed automatically using the software installed on the USB drive from Firecore.
I was originally planning on using either Boxee or XMBC to play my movies, but could never figure out how to play the DVD ISO files I created. I ended up just using iTunes and watching movies using the normal AppleTV method.
Personally, I rip my movies using AnyDVD, then transcode them using HandBreak. Once completed I just drag them into iTunes and then sync iTunes with the AppleTV.
Check out the forum on the FireCore or HandBreak sites for any help you need.