[BUG] Chat UI collapses paragraph-separated markdown into unreadable text blob

Preflight Checklist

• [x] I have searched existing issues and this hasn't been reported yet
• [x] This is a single bug report (please file separate reports for different bugs)
• [x] I am using the latest version of Claude Code

What's Wrong?

The Claude Code extension chat interface fails to render paragraph-separated markdown properly, collapsing multiple paragraphs into a single-line blob with no line breaks.

Environment:

Claude Code Extension: 2.0.31
VS Code Version: 1.105.1
OS: Windows 11

What Should Happen?

Markdown with blank lines between paragraphs should render with proper spacing, matching standard markdown rendering.

Error Messages/Logs

Multiple paragraphs separated by blank lines collapse into a continuous single-line text blob, making code review output illegible.

Steps to Reproduce

1. Have Claude output multiple paragraphs with blank line separation (not bulleted)
2. Observe collapsed rendering in chat UI
3. Export same markdown to .md file
4. File renders correctly

Claude Model

Sonnet (default)

Is this a regression?

Yes, this worked in a previous version

Last Working Version

_No response_

Claude Code Version

2.0.31

Platform

Anthropic API

Operating System

Windows

Terminal/Shell

VS Code integrated terminal

Additional Information

Evidence: See attached files:
review_output_blob.txt - markdown that collapses in chat UI
review_output_working.txt - same content with bullet list syntax (renders correctly)

Both files are identical in content structure. Only difference: paragraph breaks vs bullet list prefix (- ). Workaround: Use bullet lists instead of paragraph-separated text for all multi-item output. Environment:

review_output_blob.md
review_output_working.md