I don't know if there is really anything to fix here. It works for me. Perhaps you are still thinking of trying to do things the windows way.
Suppose you went into Mobile Me, then clicked the contact button on the top. It should bring up the contacts page. The first colum is your groups, the second column is the contacts within that group. The third column is the info on the selected contact. (just making sure we are on the same page) Your group name is probably All.
At the bottom of the group name column it should show how many contacts you have. To the left of that number is a plus sign. Click on the + and a New Group should pop up. Build your groups, then drag and drop your contacts into the appropriate group.
Jay, do you have a dotmac, mobile me, or whatever it's called? I wonder if maybe the contact groups come from that since mine work fine.
Right now, I'm syncing my contacts directly through my firm's Exchange 2003 server, and the contact categories are not coming over to the iPhone. My wife, however, sync her contacts using Mobile Me and the Address Book on her iMac. Her iPhone lists the "groups" (in Apple lingo) or "categories" (in Windows lingo) that I created in her Address Book on her iMac.
Interestingly, most of her contacts are in Entourage (Outlook equivalent on the Mac) and then are synced to Address Book, which in turn syncs to Mobile Me, which in turn syncs to her iPhone. In Entourage, she can assign a contact to one or more "categories"; however, these categories are not sent to Address Book when the contacts are synced. In other words, the syncing process is not smart enough to translate "categories" to "groups." Seems like something that should be easy enough to do, but it doesn't do it. Thus, she manually has to assign the contacts in Address Book to "groups."
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-Jay The Fine Print:Nothing in this post (or any of my other posts) is intended to constitute legal advice or the establishment of an attorney-client relationship. For purposes of this forum, I'm just another nerd like you. :-)