The compiler declares the variable in a way that makes it highly prone to an error that is often difficult to find and debug, while producing no perceivable benefits.
Your criticism is entirely justified.
I discuss this problem in detail here:
Is there something you can do with foreach loops this way that you couldn't if they were compiled with an inner-scoped variable? or is this just an arbitrary choice that was made before anonymous methods and lambda expressions were available or common, and which hasn't been revised since then?
The latter. The C# 1.0 specification actually did not say whether the loop variable was inside or outside the loop body, as it made no observable difference. When closure semantics were introduced in C# 2.0, the choice was made to put the loop variable outside the loop, consistent with the "for" loop.
I think it is fair to say that all regret that decision. This is one of the worst "gotchas" in C#, and we are going to take the breaking change to fix it. In C# 5 the foreach loop variable will be logically inside the body of the loop, and therefore closures will get a fresh copy every time.
for loop will not be changed, and the change will not be "back ported" to previous versions of C#. You should therefore continue to be careful when using this idiom.