If the game has 720p output only and your set cannot receive a 720p signal then the PS3 will downscale to 480p. 1080p games will display at 1080i or 720p depending on what you HDTV's native HD resolution is.
Right now the only problem is with 1080i sets that can not recieve a 720p signal for conversion. Because the set can not recieve and convert the signal a 720p signal would show up on these sets as snow (ie. no pictuer or sound). In this case the PS3 would downconvert the 720p signal to 480p for viewing.
While all new sets recieve 720p either as a native signal or to upconvert within the set to 1080i the first 1080i HDTVs (primarily rear projection sets and not DLP) had native resolutions of 480p and 1080i. They ignored the 720p signal until Fox and ABC started using 720p. Now all new HD sets support 720p one way or the other.