We face similar problems as well with regenerating WCF service artifacts. We have used the same separate folder technique using text comparision tools to manually merge changes.
Other strange behaviour we have noticed is the generator changing the order of elements in the XSDs and missing out includes when dealing with data contracts that implement generics.
This is not a very elegant solution and introduces all sorts of issues, I too was hoping someone had a better way. This issue is definately still in 2009, not sure about 2010.
Regards, Nikolai Blackie