Well,
Thank you very much for pointing out my careless mistake. I modified the ISR as below...
In this case, even if I alter the value at P2 to something lower than the current "counter" value, then, the system would patiently count upto 255 and then reset to 0 and start counting again. And this delay in refreshing the blink rate is prefectly acceptable.

void T0_ISR (void) interrupt 1
{
static int counter;
static int val;

if(counter == (255 - P2))
{
if(val == 0)
{
P1 = 0xff;
val = 1;
}
else
{
P1 = 0;
val = 0;
}
counter = 0;
}
else
if(counter<256)
counter++;
else
counter = 0;
}


Thanks everyone again. And congrats to myself for having received the first compliment in this forum (thanks Steve :) ) since I joined.

Cheers,
Harsha.