Probably a lot of people would know this as previous LG phones had similar video playback capability, but since LG Chocolate Touch's capability was undocumented, here is the video spec I tested and found.
Video Format: MP4, 3GP, 3G2
Max Video Resolution: 320x240
Video Bitrate: Up to 700Kbps recommended (It can play higher than this, but the playback might not be very smooth when there's fast action. So test it by yourself if you want to go higher)
Audio Format: AAC (MP3 is not supported as video)
I recommend using MP4 format rather than 3GP/3G2.
Free 3GP encoders are hard to find, and even if you find one, it won't give you a lot of options (max bitrate is 512?!).
I tested with MP4 format (MPEG-4), and the video played and looked really great with 700Kbps + 96Kbps audio. Free encoder HandBreak will do great job for this (Just change the extension to mp4, rather than default m4v). 1 hour of 700Kbps video + 96Kbps audio will be roughly 360MB.
By the way, if you make smaller video, it will try to stretch the video by default, keeping the aspect ratio, to max. possible size the phone screen can display.
But unfortunately, doing so make video run CHOPPY. (You can set it back to the original size by clicking the button located on right bottom of the screen)
This becomes a problem if you make wide-screen videos. Since your max. size is 320x240, your wide video will be 320x180, and it will be sized up to 400x224 when playing (The phone's resolution is 400x240). The video won't be just smooth and there is no work-around since the phone does not support 400x224 size.
You will need microSD card to do this, by the way. I don't think you can put these into the phone's internal memory.
You don't need any fancy expensive big class 6 card. Just cheap class 2 card will do just fine. Just get the size you want.
Once you put microSD card to your phone, it will make number of folders. Then you can either connect or move the memory card to your PC and copy your videos into "my_flix" folder.
That's it. Now, open "My Video" menu and you are ready to rock!
Just know it will cost your battery.