I've been having this issue with the Kobo Touch regardless of the firmware version.
Basically when an epub has an indented paragraph (the whole paragraph), the lines show up ridiculously short - with only 2 or 3 words per line. The only thing that works is to set the font to the smallest size, but then I find the font is much too small for reading.
Screenshots for a better explanation... one shows how it's supposed to look in Adobe Digital Editions and the other how it actually shows up on the Kobo with average font size (excuse the distorted picture):
Is there any real simple solution to this? It's quite annoying.