For 2.7, I don't think it's possible to really fix this. I see the following options:

A. current status. Byte strings are compiled correctly, Unicode strings are not.
B. compile source as a Unicode string, as proposed in msg85886. Unicode strings are compiled propertly, byte strings are not (they get compiled as UTF-8, when they should get compiled in the locale encoding)
C. prefix source with encoding declaration, as proposed in msg85882. Both Unicode strings and byte strings get compiled correctly, but line numbers in tracebacks are wrong.

Given that it's not possible to fix this without breaking something else, and given that it's fixed in Python 3, I propose to declare this as "won't fix" for Python 2.7.

In any case, the bug is certainly not in compile(), which is behaving exactly as specified, so I revert the title change.