For the record, init=/bin/bash works

And according to /var/log/apt/term.log my kernel was upgraded from
2.6.31.14.27 to 2.6.31.20.33

After upgrade there was no entry for my old kernel in grub config, so
run update-grub and got it.

initrd.img was not created for 2.6.31-20-generic during update, so I had
to start init=/bin/bash and run $(update-initramfs -k 2.6.31-20-generic
-c) to create it.

Resulting initramfs still fails to boot saying:
Begin: Running /scripts/local-top
Begin: Waiting for encrypted source device... ...
(process hangs here)

So the password to decrypt the volume is not asked.

I also run $(update-initramfs -k all) before specifying exact version it
updated initrd.img for my old kernel and now it's broken too (same
symptoms - "Waiting for encrypted source device")

-- 
[Karmic beta] System hangs after initramfs, md1_crypt (running)
https://bugs.launchpad.net/bugs/450620
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