I have managed to play discs burned with avi files.
You have burn it as a dvd video
DVD Video Discs are playable in your PS2, and because of this, they can be read without a modchip.
As long as you can boot sms on your PS2.
The PS2 is able to access any other files that happen to be on the disc alongside the video. In order for SMS to read the DVD, you have to make a dummy DVD Video disc, which can then fill up with your DivX files.
The hard work of creating a suitable DVD Video, so all you have to do is burn it with Nero, along with your video files.
Grab the dummy DVD movie here
http://www.adam.com.au/kellyjones/YABB/dvdMini.zip (144k), and unzip it onto the Desktop. or create your own DVD-Video files.
Open Nero. Select DVD, and choose to create a DVD-Video. Press New.
Select DVD option.
Drag the dummy DVD-Video files into the VIDEO_TS folder on the DVD.
Copy dummy DVD-Video files
Fill up the rest of the DVD with your favourite DivX and MP3 files.
Burn the DVD. You can now play it using SMS.