You must be confusing "Xbox Live Arcade" with "Xbox Live Indie Games". Indie games are written in XNA/C#. Everyone can download the XNA software development kit and develop indie games.
XBLA games are mainly written using XDK/C/C++/ASM just like all the retail titles, and are tested using the hardware development kits. Unlike Xbox Indie Titles (written in C#), the XBLA titles developed using XDK can fully access the hardware. I don't know where you got the "unsupported path" information from, but that information is not correct. All the major graphics heavy XBLA games are developed using XDK.
I doubt we see major graphics heavy titles such as Battlefield 1943, Trials HD, Portal and Toy Soldiers on the phone anytime soon. Even if the developer is willing to port hundreds of thousands lines of C++ code to C# (all their existing technology), there is one additional huge problem remaining: The phone does not support programmable shaders yet. At launch there are only a few very limited Microsoft made shaders available. So you can forget real time shadows, per pixel lighting and all your fancy post process effects (HDR lighting, light blooms, depth of field, motion blur, etc).
Hopefully we will get full shader access in the future, and the option to write native C++. Otherwise it will be rather difficult for Microsoft to get all the biggest game development companies behind their device. So far there has been no big announcements for existing gaming frachises. Only small indie games have been shown. I doubt this is the strategy Microsoft is the most comfortable with.