This is cheating a little, but quicker:

# If you have any spare characters to use
# (lets say '~')
sub my_squish {
 local $_ = shift;
 s/\n{2}/~/g;
 s/\s+/ /g;
 s/~/\n\n/g;
 $_;
}
[download]

Update: True enough japhy, but I said I was cheating :) And even though it scans the string three times, its simple and quicker than doing the reversing, lookaheads & lookbehinds necessary to do it in one regex.