Index: wp-includes/formatting.php
===================================================================
--- wp-includes/formatting.php	(revision 11263)
+++ wp-includes/formatting.php	(working copy)
@@ -120,16 +120,16 @@
 	$pee = preg_replace('|<br />\s*<br />|', "\n\n", $pee);
 	// Space things out a little
 	$allblocks = '(?:table|thead|tfoot|caption|col|colgroup|tbody|tr|td|th|div|dl|dd|dt|ul|ol|li|pre|select|form|map|area|blockquote|address|math|style|input|p|h[1-6]|hr)';
-	$pee = preg_replace('!(<' . $allblocks . '[^>]*>)!', "\n$1", $pee);
-	$pee = preg_replace('!(</' . $allblocks . '>)!', "$1\n\n", $pee);
+	$textblocks = '(caption|td|th|div|dd|dt|li|pre|blockquote|address|p|h[1-6])';
 	$pee = str_replace(array("\r\n", "\r"), "\n", $pee); // cross-platform newlines
+	$pee = preg_replace('!(<' . $allblocks . '[^>]*>)!', "\n\n$1\n\n", $pee);
+	$pee = preg_replace('!(</' . $allblocks . '>)!', "\n\n$1\n\n", $pee);
 	if ( strpos($pee, '<object') !== false ) {
 		$pee = preg_replace('|\s*<param([^>]*)>\s*|', "<param$1>", $pee); // no pee inside object/embed
 		$pee = preg_replace('|\s*</embed>\s*|', '</embed>', $pee);
 	}
-	$pee = preg_replace("/\n\n+/", "\n\n", $pee); // take care of duplicates
 	// make paragraphs, including one at the end
-	$pees = preg_split('/\n\s*\n/', $pee, -1, PREG_SPLIT_NO_EMPTY);
+	$pees = preg_split('/\n(?:\s*\n)+/', $pee, -1, PREG_SPLIT_NO_EMPTY);
 	$pee = '';
 	foreach ( $pees as $tinkle )
 		$pee .= '<p>' . trim($tinkle, "\n") . "</p>\n";
@@ -141,6 +141,8 @@
 	$pee = str_replace('</blockquote></p>', '</p></blockquote>', $pee);
 	$pee = preg_replace('!<p>\s*(</?' . $allblocks . '[^>]*>)!', "$1", $pee);
 	$pee = preg_replace('!(</?' . $allblocks . '[^>]*>)\s*</p>!', "$1", $pee);
+	// turn <li><p>foo</p></li> into <li>foo</li>
+	$pee = preg_replace('!<' . $textblocks . '([^>]*)>\n<p>([^\n]*)</p>\n</\\1>!', "<$1$2>$3</$1>", $pee);
 	if ($br) {
 		$pee = preg_replace_callback('/<(script|style).*?<\/\\1>/s', create_function('$matches', 'return str_replace("\n", "<WPPreserveNewline />", $matches[0]);'), $pee);
 		$pee = preg_replace('|(?<!<br />)\s*\n|', "<br />\n", $pee); // optionally make line breaks