The Knots2 wiki says it transcodes to flv when using the "browser profile". I find that the "N900 profile" looks a lot better, there's a lot of macroblocking on the browser transcode.

In the local settings, accesed in the localhost:1978 address, there are settings for each transcoding package, and it shows that the N900 setting is transcoding to XviD. So I don't think a wrapper is being used.

There are a lot of settings to tweak, you can even tweak VLC's setings. So far I haven't found a sweet spot for 1080, but 720 seems watchable with default N900 settings.