I have this same problem too. When I view the lit file in MS Reader, it looks fine, but conversion makes it one big paragraph. I tried the "treat each line as a paragraph" option, but the result was a non-text-wrapped file that crashed ADE.
Converting to mobi didn't result in a workable epub file, and converting to lrf created an lrf that calibre wouldn't convert at all. (I do have an older version of calibre, so I may have to update it before continuing.)