Optimisation doesn't affect the ability to single-step, nor to set breakpoints.

The problems lie in knowing where exactly to set the breakpoint - because the breakpoint has to be set on a real physical address, and it's hard to know which real physical address(es) correspond to a source line. Similarly, trying to relate a source-level "single-step" to the right set of machine instructions is very difficult!

You can do it, but it is very difficult - because the tools give you (virtually) no help at all!

Again, this is really a deficiency in the debug tools - they are just waaaaaaaaaay behind the capabilities of the current code-generation tools!

The debug tool developers really need to pull their fingers out and catch up with the code generators!
See: http://www.8052.com/forum/read.phtml?id=140126

This really shouldn't be that hard for people like Keil who have full visibility of all the inner working of the code-generation tools - they really should be able to come up with a truly Integrated Development (ie, including debug) Environment.
It would, presumably, be harder for 3rd-party debug tool developers without the internal knowledge of the generation tools.