I have managed to make it work. After changing config/environments/
development.rb to look like:

config.action_mailer.raise_delivery_errors = true
config.action_mailer.perform_deliveries = true

config.action_mailer.delivery_method = :sendmail ####

Now everything works fine on my system. Adding config line marked with
'####'  to make rails use :sendmail and restarting mongrel made
everything work perfectly.

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