You're not dreaming. It's working correctly. What you are doing is smoothing the geometry, and I think what you want to do is smooth the shading -- two different but related elements.

To smooth the shading on the object, you need to average the normals along that hard edge. Simplest method is to select the poly shape and select Edit Polygons | Normals | Average Normals. Average Normals can operate at the component level, so you can experiment with that as well.