I know this stuff is all fairly old but there are many people still playing this game and may have the same problem as me and not found the solution.
First of all..I installed the Kotor 2 and the 1.0b update to the game. It ran fine on my laptop which is running a re install of Windows 7 (my graphics card is ATI Xpress series 200M i think). No problems with movies or anything like that.
My laptop had to be re installed too it was running Window Vista home premium when I bought it. I got a shop to do this cos I could not be bothered.
Now the only problem I did have was Kotor 2 character models were very strange. The face was separate from the head and the body was on it's side floating (SO ANNOYING). I tried all this websites fixes and did many installs trying many graphical options, all to no avail. I just about gave up and went to reading something else which was for a separate matter.
"sometimes on windows 7 graphics card drivers get mixed together and have problems running properly although the effects might not be obvious it causes many gaming issues."
So what I did: I downloaded (NOT INSTALLED) the latest driver pack from ATI Radeon website and the catalyst manager. Then went to the uninstall software area and completely uninstalled anything to do with ATI which resulted in my screen looking like a computer from the 70's
. Restarted the computer, went to the hardware manager and manually sourced the driver for my card (when you find the file it gives you a massive list for many cards. I installed the "Xpress series" and not the one for Xpress 200M). Restarted my computer again, installed the new catalyst manager. Finally replaced the Mss32.dll and hey presto problems were solved and game runs fine.
Just thought I would share that for those who might be pulling their hair out
. I'm ATI but I'm sure it would be similar for other cards too.