Before upgrading to 1.8 (Oct 2012) this is how we configured our sites in the ServiceDefinition.
Yes, this was an official change, but I can't find any documentation about it other than what is contained in the upgrade report:
"The physicalDirectory attribute '..\MyWebRole' of the Site element contains a relative path. This path is relative to the directory in which the target Service Definition file resides when packaged. In previous versions this file was located within the root project directory. In this version, by default, this file is located in the project output directory. You may need to update the relative path to reflect the new location of the target Service Definition file."