Your TV+microconsole (or your computer) becomes a gaming thin client. The game runs in the cloud, and only the sound, display, and controller actions are transmitted between the thin client and gaming server. i.e. the Netflix model
I got the microconsole for $50 with a free game, and I must say, it works surprisingly well.
My main problem is that you actually have to buy the games and then not even own them. I've already bought them once on Steam, why do I have to buy them again to play there? A Netflix-style model of per-month payments for unlimited time would be better, but having to buy the games again is a joke.
I agree with you though, having to buy games I've already bought once is annoying. But unless storefronts/publishers all agree to hold hands, sing Kumbaya, and honor each other's purchases, I don't see another option.
They use their own hardware, not EC2 or anything like that. They need gaming-level GPUs and they have their own compression hardware.
The same goes for the full-price titles on OnLive. The playpack is different, it's the same flat monthly fee model as Netflix. And you can also rent the full-priced titles for a short period of time instead of buying them.
Some games can be bought. So long as the OnLive servers run, they're yours and you don't need to pay a monthly fee (as with Steam games).
Some games can be rented. For a few dollars you can get full access to the game for a time-limited period (24 hours or a few days). The first 30 minutes can usually be obtained free as a demo.
Some games are available in a playpack. This pack has a monthly fee like Netflix. So long as you keep paying the monthly fee you can play any of the games in the playpack (there's about 50) as much as you like.