That's simple to explain. The graphics subsystem easily supports outputting 1080p video. However, the iPad 2 has the same screen resolution as the original iPad, 1024x768. This means that the device itself only supports up to 720p, since 1080p is 1920x1080.
720p is 1280*720; so the device can't display 720p. I think what the spec there is talking about is that it can decode video up to that resolution - it's more of a codec performance number.
