I found the following workarounds:
During grub boot (or in /boot/grub/menu.lst) edit the kernel options to include 
nosplash nomodeset
There is still an error during X startup but now the "Exit to console login" 
works (consoles are no longer all black).
Also after exiting to the console, sometime later an X server with kdm 
successfully starts on virtual console 8! (I have never before had an X server 
run on VC 8).

Once you can get to a working console login you can
sudo dpkg-reconfigure gdm

For me this allowed X to start normally on VC7 without any errors. (I
guess you have to be sure that gdm is installed before this will work
:-).

-- 
after recent update which included xorg, xserver etc causes low-graphics mode 
error at start
https://bugs.launchpad.net/bugs/491483
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