First, I'd start looking for an updated Windows7 compatible video card driver. Since the mkv format is only capable of 1080, you'll have to adjust your resolution to avoid the distortion
You can read more about that here:
divx, h264, and (maybe) mkv on Windows 7? | Digitalwerks

You may also benefit by downloading the Windows7 Codec pack

Win7x64 Components 1.1.5 Final
|MG| Win7x64 Components 1.1.5 Final

Here's another 64-bit version of the popular K-Lite codec pack:
K-Lite Codec Pack 64-bit

This includes FFDshow which is highly configurable

Please read carefully before downloading and create a restore point as well.

Actually, the problem is not that the film doesn't fit the screen. I expected it to play at its natural aspect ratio. Its just that when its doing so there is a blurry bar at the bottom of the video. As the pictures I've posted will show.

I had tried every single driver available but the problem persisted. I'm currently on Windows 7 desktop drivers, on my laptop.
9800m GTX - should be able to handle the playback.
And it does, naturally, in WMP12 and MPC HC. And there are no blurry bars in those players. Its just in Dreamscene that these issues occur. If you take a look at the blurry bars in the pictures of my original post, they are endemic of the issue.
I want to know if these bars are recogniseable to anyone who has used Dreamscene or played h264 in WP12 before.

I did try your WIN 7 codec pack, and uninstalled it because it achieved the same effect as the single MPC homecinema filter I downloaded from their website to play MKV. WMV12 doesn't recognise MKV on its own. I only hope uninstalling the codec pack didn't leave anything on my pc and won't cause me problems later on, I'm sceptical of codec packs.
The problem remains.

Additionally, I need to know how WMP12 relates to dreamscene and if I can tinker with WMP12 controls to get my video to play without the blurry bar and slight stutter on slow panning scenes. Not that I can find any settng options in WMP12, anyway...

Yes, there may be some remnants left behind

Since you've already uninstalled, if you're an advanced user and understand the registry, you can download this freeware program to search the registry for an instances of the codec pack that remains. You can search for name of company, name of directory where the codec pack was installed, and/or by filename

Regseeker:
RegSeeker - Free software downloads and reviews - CNET Download.com

I'd also suggest this freeware utility for uninstalling programs...it catches more registry keys and files left behind after the programs uninstaller finishes.

RevoUninstaller:
Revo Uninstaller Freeware - Uninstall Software, Remove Programs, Solve uninstall problems

You can also download this free open source program called Regshot, which allows you to capture all registry entries and files added to the system. You can take a snapshot before an install to determine that. If you want to uninstall, you take another snapshot and compare the two for leftover entries and files. I always use this program before any install I do. It's called Regshot and can be downloaded here:
|MG| RegShot 1.8.2

I'm not absolutely certain, but I don't think WMP plays any role with Dreamscene. All you need is a multimedia player that supports the .wmv format. One that does is the open source Video Lan Player. You can download it here:
|MG| VLC media player 0.9.9

Regarding options for codecs in WMP, go to Tools > Options, then the DVD tab ands click the Advanced button to view the codecs installed.

You can also go to Default programs, select WMP and see what file extensions it's associated with.

I believe the only format that Dreamscene plays is the fil extension .wmv.

Actually, if your only testing a program, you should always create a restore point. This would probably be the best option.

Well, dreamscene only played .mkv for me when I installed a codec for the film to play in WMP12 and renamed the MKV to WMV, getting it to play in both.
So maybe the applications are related after all? Although, the blurry line doesn't occur in WMP12 at all, and if they're not related then I'd like to know how one can toggle Dreamscene options at all!

Still, if anyone recognises the particular visual quirk of those screenshots please help.

I would suggest downloading VLC Player, or Windows Media Player Classic : Home Theatre.

I was experiencing similar issues with h.264 playback as well, and I used these video players instead, and have had crystal clear screens no problem.