I figured it out. It only works with iPhoto, not in iTunes. I was expecting it to work in iTunes which seems natural to me but oh well.
Open iPhoto and the iPhone actually appears as a disk drive on the left under 'source'. Then you can download the photos taken with the iPhone. But you have to do it in iPhoto. It will not appear on the Desktop or anything.
White 32GB iPhone 3GS, Mac Pro, Macbook Pro.