Hi - I assume since you say the server side setting is to "Markdown" that you are using MarsEdit 3.3, where I added this feature for Server Options to select the format for Squarespace.
Is it possible that you are trying to edit your post in "Rich Mode" in MarsEdit? If you type your content in Rich Mode, it will not be interpreted as Markdown, but always as literal content for your blog post.
If you want to use Markdown in your posts, make sure to switch to HTML mode (Post -> Edit HTML). I know this is a little confusing, but the rich editor in MarsEdit is intended only for generating HTML for what is literally typed or pasted in. If you want to use a markup language like Markdown you have to enter it in HTML mode.
Hi Paul - yes, you can change the default to HTML text in Preferences. Look under Preferences -> Editing for an option to choose whether posts should open in Rich or HTML Text mode.