RedCloth 3.0.4 seems to be broken. For some reason, it doesn’t transform paragraphs correctly. The quick fix is to downgrade to 3.0.3. Here’s how I did it.

gem list --local
...
RedCloth (3.0.4, 3.0.3)
    RedCloth is a module for using Textile and Markdown in Ruby. Textile
    and Markdown are text formats.  A very simple text format. Another
    stab at making readable text that can be converted to HTML.   
...

First, install 3.0.3:

sudo gem install --remote redcloth --version "3.0.3" 

Then uninstall 3.0.4:

sudo gem uninstall redcloth
Attempting to uninstall gem 'redcloth'

Select RubyGem to uninstall:
 1. RedCloth-3.0.3
 2. RedCloth-3.0.4
 3. All versions
> 2
Successfully uninstalled RedCloth version 3.0.4  

A reference article from the mailing list:

• http://www.ruby-forum.com/topic/49547

Disclaimer: Use this stuff at your own risk. These are not instructions – this is just what worked for us. We can take no responsibility for anything that might happen to your server as a result of following these steps.