I think this is one of those toss-up scenarios that depends a good deal on your equipment and your personal preferences.
The theory behind switching video through your receiver is basically twofold: first, if you have just one video connection from your receiver to your TV then you should be able to change both your picture and sound with one button-push; and second, your receiver may have its own on-screen display that it can add to your video signal, which will make using functions or setup on your receiver easier. For example, it migt tell you what format of digital audio it sees so you know whether you've set everything up correctly ("Hey, it says 'Dolby D' but I thought I picked the DTS track!").
In reality, not all input devices run in the same format, and I don't think it's common for receivers to do any video transcoding. I have a receiver with half a dozen component inputs and component switching, but my VCR is ancient and has only composite video. It's not selectable through component out, so I need to hook it up directly to my TV. Digital video poses the same problem, although only my DVD player currently supports that so there's no point in switching.
I have to wonder about the on-screen display with digital video, too. With analog video, adding a display is a matter of syncing and filtering the video signal at the right place to add the display signal. Digital video is compressed and encrypted, so it seems likely that adding an OSD might not be possible. However, that seems like a valuable feature to lose to digital video. Has anyone actually seen this work (or not work) with DVI/HDMI switching?
Your point about individual input settings is a good one--you lose that with switching. Maybe someday everything will be HDMI (or backward-compatibe digital video) and we'll finally have no-compromise one-button switching.