Problem
Upgrading from Rails version 1.2.3 to version 2.0.2.
Following the suggestion in DH’s weblog here when using sudo gem install rails -y, it gets the trunk version of rails which at the time was 2.0.2.9216.
This causes a few problems and breaks a few more things.

Solution
In order to get back to the latest stable version, you have to uninstall a few of the gems installed from the trunk version.
If you have installed the latest version of top of an existing one using gems, then doing:

gem list --local

will give you all the installed versions of the gems. Something like:

actionmailer (2.0.2.9216, 2.0.2, 1.3.3)
actionpack(2.0.2.9216, 2.0.2, 1.3.3)
rails(2.0.2.9216, 2.0.2, 1.2.3)
...

Make sure you uninstall all the gems with version number 2.0.2.9216:

sudo gem uninstall rails
sudo gem uninstall actionmailer
sudo gem uninstall actionpack
sudo gem uninstall activerecord
sudo gem uninstall activeresource
sudo gem uninstall activesupport
sudo gem uninstall rails

In each of the above commands the gem package manager should ask you to select the one you want to uninstall.
Pick the one with the 2.0.2.9216 (or other version later than 2.0.2).

At the end if you list the gems again you should only have gems going up to version 2.0.2

An extra step I had to take for making the migrations work was to install rake again:

sudo gem install rake

After all these my installation seems to be working fine again.