I was curious about your question, so I downloaded one of my own youtube videos in 720p from keepvid. I dropped it into the project window, then dropped it on the new item icon. Guess what. It played perfectly in Premiere. No need to transcode to anything.
I used keepvid and downloaded a 720p file as well.
I dragged the file into Premiere. From Premiere I click+dragged it onto the 'New Item' icon in the Project window and it made a new sequence containing the clip. However the clip in the sequence had the yellow bar above it and during playback it was very pixelated (though normal quality when frozen).
What sequence settings do you have?
> However the clip in the sequence had the yellow bar above it...
That is not a problem. See this page:
> ...and during playback it was very pixelated (though normal quality when frozen).
Check the setting for playback resolution in the Source Monitor panel or Program Monitor panel. It sounds like you have it set to soemthing other than Full. See this page.