Yeah the camera is way better in Froyo. I honestly never had any problems with the camera to begin with EXCEPT that video playback would often hiccup and as a result the audio would fall terribly out of sync. So far I have not had this issue. The addition of the LED on or off option is cool however it's not a big deal unless you're filming something fairly close up. Also I already have MotoTorch which I used with video.
I had the same issue as OP reported, but I did a battery pull and it started working again. Although now the side camera physical button isn't working...