Thanks for the responses!
However, I think this may just be a network issue. I had this problem with AT&T, I just recently switched to Verizon and with the same settings on the phone (albeit I now have an iPhone 4S), I can now group text with more than 10 people!
If it is really an issue for you, you may need to switch carriers, otherwise I am afraid there may not be a solution to this, as I think I tried everything on my AT&T iPhone 4 (iMessage vs. SMS vs. MMS, etc.).