Good point, maybe the pvp flags idea would be the best way to go. Would even be cool to be "non-pvp flagged" and then some pvp flagged person try to attack you and you take no damage since you are non-pvp (like wow, etc..) they can attack all they want but you in essence have "god mode on" from pvp damage while in non-pvp state.
As there are only 32 people per instance (as I remember), completely separating the groups in different instances would be the best IMHO.