My main dvd player is PS3 which is superb upscaler, but I also have a R599 Philips DVD player from 2 years ago, and it does a very good job of upscaling to 1080p. If you look closely not as good as the PS3, but very decent with no pixelation or any other serious picture distortion.
Strange that a BD capable player (newer/more powerful DSP scaler) would create such a bad/corrupt picture? Have you tried setting the LG to different output formats e.g. 1080i, 720p, 576p etc. to see if the TV's DSP can do a better upscaling/de-interlacing job (shouldnt).
Also an upscaled dvd picture will never match a true 1080p source, maybe you need to tune your TV's settings a bit to de-emphasise the imperfection e.g. brightness, contrast, sharpness, gamma, HDMI black levels, digital/mpeg flitering, colour space, film mode etc.
Will fiddle with it tonight