Watching a movie in MKV format..it is gorgeous....why?

[Fumesucker]

3. AVI and MKV are both just containers of video data, how the data is encoded and compressed varies

http://en.wikipedia.org/wiki/Digital_container_format

http://en.wikipedia.org/wiki/Matroska

The Matroska Multimedia Container is an open standard free container format, a file format that can hold an unlimited number of video, audio, picture, or subtitle tracks in one file.[1] It is intended to serve as a universal format for storing common multimedia content, like movies or TV shows. Matroska is similar in concept to other containers like AVI, MP4, or Advanced Systems Format (ASF), but is entirely open in specification, with implementations consisting mostly of open source software. Matroska file extensions are .MKV for video (with subtitles and audio), .MK3D for stereoscopic video, .MKA for audio-only files, and .MKS for subtitles only.[2]

The name "Matroska" is derived from the Russian word Matryoshka (Russian: матрёшка [mɐˈtrʲoʂkə]), which means nesting doll (the common Russian cylindrical-shaped doll within a doll, also known as a babushka doll). This is a play on the container (media within a form of media/doll within a doll) aspect of the matryoshka as it is a container for visual and audio data.

The clarity of the video is much more dependent on file size and encoding standards than on the particular video container that might be used, all else being equal the bigger file just has more data to put on the screen so it's going to look better.

You see the same thing with JPG image compression, some programs will let you vary the amount of compression in your JPG images when you save them, highly compressed images (small amount of data) just aren't as clear as the same image with less compression (more data), the more compressed the data the less clear the image.