Unable to play SD .AVI file?

can’t say i have any “Interlaced” content  (i know from testing on the WDTV 1080i@50hz works ok for PAL interlaced content … but yours in NTSC, so i don’t know how that will look)

Have you considered trying Handbrakes “Deinterlace” option for H.264 ?     Video Filters > Deinterlace

For an explanation of the Fast, Slow, Slower settings click this link

https://trac.handbrake.fr/wiki/DeinterlacingGuide