LinuxMCE does read dvd iso files, although I am not sure if it needs them to have a .dvd file ending or if it supports the .iso extension. So, yes, I think what you want is possible. To be able to properly access them in LMCE, you need to tag them after adding them, so that you could browse them by title, director, etc. This can be done either manually or, I think, by using the more automatic imdb lookup.
You could always re-encode the video files, but you might loose some quality. Depends what format they are in and what size you are looking for.