Solution thanks to Dave Lenef.
As I have learned, this is caused by firmware malfunction, particularly during the OS upgrade. From version 3 to 4.2.
Solution is simple, though may take long time to complete depending on user's data.
1. Do a normal sync first and then Restore iphone again with itunes.
2. Choose backup to regain data after restoration, instead of choosing NEW settings.
3. Normal synchronization and most data and apps should be back. All seems to be back on mine with some past apps I deleted.