Ok, I'm not the ideal person to try and give an answer since my knowledge of this matter is entirely lacking in technical data to back it up and it's based entirely upon personal perception, but here goes:
Firstly, the texture size setting in game (i.e. Large, Medium and Small) will work whether you're using Vanilla res textures or a high res texture pack.
I have no idea HOW it specifically works, but I do know that if I'm using a 2048x2048 high res tiling grass texture instead of a 512x512 Vanilla one and I set the texture size setting in game to Medium, the 2048x2048 texture will look like it's about 1024x1024. If I have it set to large, it'll appear at its full resolution. If I set it to small, it'll appear to be about 512x512.
Basically, if you set the texture setting in game to Large, you should see the textures at their natural resolution - whatever that may be. At least that's how it appears to me. If you set it to Medium, textures seem to perform and look as though their resolution has been halved.
I could be totally wrong, I don't pretend to know about this sort of thing, but the general idea I get is that Large = Natural res (i.e. whatever size the texture actually is). Medium = 1024. Small = 512.
Because anything less than Large results in hard to read signs and poor looking armour and clothes, I always use the Large setting.
When creating my own landscape textures recently, I made the majority of them triple the res of most standard Vanilla textures. (i.e. 2048x2048.) But, in the interest of half-decent performance on my crappy old pc, I also made an alternate version which was largely 1024x1024.
If I run the High Res version (2048x2048) on Large, it appears exactly the resolution it was created at and performs accordingly.
If I run the High Res version on Medium, it appears and performs as though it's 1024x1024.
If I run the Medium Res version (1024x1024) on Large, it appears exactly the resolution it was created at and performs accordingly.
If I run the Medium Res version on Medium, it performs accordingly but it looks slightly worse quality-wise than 1024 should.
Sorry if the above is a mess of inaccuracy and confusion.
But that's a rough idea of how it SEEMS to work / behave.