Damion over at Zen of Design has a thoughtful post up about death penalty design in MMOs.
Having started out playing Diku- and LPMUDs and losing a painfully hard-won level with each death, I come down firmly on Damion's side of the death debate.
City of Heroes/Villains and Guild Wars handle this the best of the current crop of games, in my opinion. Death (sorry, "defeat") in CoH costs you XP in the form of debt that you have to make up before you can make further progress toward your next level.
Guild Wars is better yet, docking your stats by a percentage that you can work off. You feel this change in subsequent battles, especially if you've racked up a lot of deaths and your health bar is half what it usually is, but you haven't been materially prevented from progressing in the game or enjoying it.
The above marks me as a casual player of MMOs, I realize. I just don't have time to play more than casually these days, but you know what? Even when I was playing hardcore, corpse runs were no fun. They were the anti-fun. They provided unnecessary friction to the play experience, and challenge and friction aren't the same.