I had the same problem - I didn't know the middle button still worked.
Did you compile PS/2 mouse support in or as a module?
I think this problem occurs only with the module psmouse, but I'm not sure - I wouldn't recompile if it takes ages - I've got it working with 2.6.6, but I've got problems of my own.
I've got (not 100% cert as I'm in Windows atm):
<*> PS/2 Mouse Support
<*> PS/2 Mouse Support /dev/psaux by default
and a couple of others in the same place that say they are required for PS/2 devices.
Not very helpful I know, but at least I know I'm not alone.