Not whining about Apple in any way, but if by "solution" you mean PLA's comment that the only way to retain the artwork on downward converted files is "to TURN OFF the 'Convert Higher Bit Rate Songs to 128 AAC' on your device," I've got to disagree with you. It is, in fact, the convert feature that is broken, as of the last update (it worked perfectly well before.) "If it's broke don't use it anymore" is certainly a logical response to something that doesn't work properly, but it ain't a solution.
I've tried all the things mentioned in this thread and nothing changes the fact that "convert to 128 AAC" now removes the artwork from the files it converts. Of course, I imagine that creating new, duplicate files in iTunes at 128 and copying them to your iPhone instead of the higher-rate files, as one commenter suggested, would "work" too, but only because the convert feature that is not working won't be part of that process at all. I lost interest trying to do that halfway through typing that sentence. Synching between iTunes and your iPhone shouldn't be that much of a hassle, and it sure didn't used to be.
(Kind of curious, btw, if this also happens with iPod Touches: I mean, I guess it would, wouldn't it?)
Space (i.e., more songs) is more important to me than the pretty pictures, so for now my approach is just "live with it and hope it gets fixed somehow in a future update" (i.e., solution!) But I'd prefer to have both the pictures and the files, and of course I'll keep checking this thread to see if anyone figures out something better than just living with it.
As always, appreciate the help.