You can't boot the livecd image from grub, you'd have to select the 'install to harddrive' option and install it on the usb stick, but you will need more than 4gb free (yup, I know that's annoying, why 4gb isn't enough is a mystery).
I've done this on an 8GB SDHC card and all works fine, grub can now read the filesystem.
GRub is due to be upgraded this year to the imaginatively named grub2
, beta testers report booting from iso9660 filesystems such as livecds.
sorry, I forgot you were booting from a usb stick not a livecd iso. OK, are you sure you have the directories correct, aren't vmlinuz0 and initrd0 in the syslinux directory (not isolinux)