The attached patch fixes the problems with patch 7.2.356 (by actually
reverting the patch) which caused the folds to be closed in too many
situations.
Changes:
- in case of 'foldmethod' change the folds are closed only if 'fdm' is
  changed to 'diff',
- folds are closed when one of the following commands is used:
  :diffsplit, :diffthis, :diffpatch.

To decrease the likelihood of undesired side effects the code handling
the normal zM command has been reused.

My apologies for the problems introduced by 7.2.356.

-- 
Cheers,
Lech

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diff --git a/src/diff.c b/src/diff.c
index f5ea0c6..b646329 100644
--- a/src/diff.c
+++ b/src/diff.c
@@ -1117,6 +1117,12 @@ diff_win_options(wp, addbuf)
     win_T	*wp;
     int		addbuf;		/* Add buffer to diff. */
 {
+    win_T *curwin_saved = curwin;
+    /* close the manually opened folds */
+    curwin = wp;
+    newFoldLevel();
+    curwin = curwin_saved;
+
     wp->w_p_diff = TRUE;
     wp->w_p_scb = TRUE;
     wp->w_p_wrap = FALSE;
diff --git a/src/fold.c b/src/fold.c
index ff1139d..405a6ef 100644
--- a/src/fold.c
+++ b/src/fold.c
@@ -849,17 +849,11 @@ foldUpdate(wp, top, bot)
     fold_T	*fp;
 
     /* Mark all folds from top to bot as maybe-small. */
-    (void)foldFind(&curwin->w_folds, top, &fp);
+    (void)foldFind(&curwin->w_folds, curwin->w_cursor.lnum, &fp);
     while (fp < (fold_T *)curwin->w_folds.ga_data + curwin->w_folds.ga_len
 	    && fp->fd_top < bot)
     {
 	fp->fd_small = MAYBE;
-
-	/* Not sure if this is the right place to reset fd_flags (suggested by
-	 * Lech Lorens). */
-        if (wp->w_foldinvalid)
-            fp->fd_flags = FD_LEVEL;
-
 	++fp;
     }
 
diff --git a/src/option.c b/src/option.c
index 99e94d5..746945e 100644
--- a/src/option.c
+++ b/src/option.c
@@ -6586,7 +6586,11 @@ did_set_string_option(opt_idx, varp, new_value_alloced, oldval, errbuf,
 		|| *curwin->w_p_fdm == NUL)
 	    errmsg = e_invarg;
 	else
+	{
 	    foldUpdateAll(curwin);
+	    if (foldmethodIsDiff(curwin))
+		newFoldLevel();
+	}
     }
 # ifdef FEAT_EVAL
     /* 'foldexpr' */

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