It appears it has something to do with the headphones. It won't accept the bitstream directly, but as soon as I turn on linear PCM it works fine, and then the headphones simulate the surround sound... so I guess I'll just leave it as and switch to linear PCM any time I need to for the headphones...
I do love the headphones. They sound great. I've had surround sound for a long time and love it, and this is probably as close as you can get without actually having 5 speakers. Haven't used them a ton for movies yet, but games on the 360 is really solid. Occasionally I'll notice a sound going from one cup to the other a little too rapidly, but it's rare.
Been playing a lot of Halo 3: ODST so I'll tell you about my experience with that. The ambient rain/stormy sounds are really solid, the other night I thought thunder was from outside, but it was the headset. I can tell exactly where an enemy is relative to me based on sound alone. Frankly being able to have the volume up a moderate level, and the speakers so close to my ears not only makes it easier to detect exactly where they are, but has also allowed me to pick up dialogue I hadn't heard before.
I'm sure a lot of this relies on the sound mix, but so far (had them 3 days now) these headphones are awesome and well worth the money if you either can't afford full surround sound or need a solution for playing late at night (I do, and I don't want to piss off my neighbors)
I did throw in The Dark Knight on blu, the scene under ground with the batpod and the truck flipping over and all that, sounded amazing on the headphones.
And I have to say IMHO the headphones do a better job with dynamic range compression (if that's really what I'm thinking of) because I feel I in general hear dialogue better, and music and sound effects are more balanced (vs what I feel is more common - dialogue being unbelievably quiet and music/action way, way too loud).
I have read a lot of mixed opinions though, so YMMV.
Also, they're really comfortable. I've been wearing them for almost 3 hours as I type this and am still good to go.