Yes, I'm getting the same problem as well.
I have to close and re open the app multiple times before it will only show music on my iPhone.
It also keeps switching itself back on, this seems to happen when I plug my phone in to my computer, and then when I'm in the car, I have to go through the whole process of closing the music app, re opening, toggling the "Only Downloaded Music" option, closing, re opening etc.
Can't we just have an option is setting that will switch it on for good, I don't want to see every song on my phone, living in a rural area means I only get GPRS coverage most of the time, so even if I wanted to play my entire music collection, I can't.