When you look at the html of your post or page (or what is stored in $wpdb->posts.post_content), you'll notice that there are no <p>'s but instead just double spaces. Somewhere between when WordPress reads the content from the database and when it displays it on the page, it recreates a <p> from double spaces.
Why do I need to know? I whipped up a little hack/plugin that adds the TinyMCE editor onto the excerpt field to allow for formatting. All works fine, except for the functionality I described above. For example:
What I put in:
First line
Second line
Third line
What gets displayed:
First line Second line Third line
Thanks! Any help would be appreciated.