Yes, this works really well as it's the setup I have. To make this work I found the best thing to do is as as follows:
1. Install Estrongs File Explorer (ES File Explorer is free in the market)
2. Using ES File Explorer, go onto the LAN tab and add a server (you can scan for it if you are not sure of your WDTV Live's IP Address, but I've found that it doesn't remember scanned devices). Best to add it manually if you can.
3. Once it has been added you can just browse under the LAN tab, select WDTVLIVE and it will show you all the currently mounted devices.
4. Just click on the file you want to watch (or any other type of file the Nexus 7 can open), choose the media player you want to use (if you have more than one installed) and it's job done!.
I would also suggest installing MoboPlayer as it supports many different video formats.
So far the only thing I'm not able to play (consistent with everyone else in the Android universe!) are .ISO DVD images.
A couple of other useful tips:
In ES File Explorer, if you long press the file you want to play you can choose the type of file and then what app you want to open it with.
When you add the WDTV drive, just add its IP Address. This means that when you browse it in ES File Explorer it will always see whatever drive is connected.
This all works brilliantly over wireless for me
Hope this helps.