Thanks Brett!
I have seen the article you are referring to, and it was not useful. I checked two other iPhones4 with the same version of IOS and they connect to my Volvo stereo and play Pandora without any problems. So the issue has to be with my specific phone (not with the car, or the cable, or the way I hook them up).
Based on the error I see displayed on the Volvo screen, it looks like the initial handshake between the Volvo stereo and my iPhone fails (i.e. iPhone does not look like a "familiar device" to the Volvo stereo interface).
I will try to load some music locally onto my iPhone and see if I can feed that into the Volvo stereo. If I can, then I will try to re-install Pandora. If playing local music fails too, then it would appear to be some sort of the I/O interface problem with my specific phone, and I am not sure how I can debug that ...