First, I don't see why people are at all sad the thing blew up. It was a test article, and test articles break, generally with tons of instrumentation to tell you how. If you want to feel sad, feel sad for the upper stage testing guy, who won't see a video of his machine airstarting for another six to nine months. And that's what motivates the rest of this post.
Why does the vehicle have to be tested all-up? Testing all-up is gutsy and smart when your expectation of failure is very low, but wasteful if you are pretty sure you have multiple problems to find and fix. Dwayne Day has pointed out that about half of all new rockets succeed on their first launch, but this launch was not like the first launches of most of those other rockets. Those rockets had very expensive Big Government testing programs behind them. This rocket did not. That's good (because it can be more efficient), but it means that an all-up launch is not likely to yield a lot of testing data for the amount of money and time invested.
At this point, SpaceX has already paid for plenty of expensive lessons at Kwaj, so incremental flight testing might not seem necessary anymore. I'd do it anyway: they'll need it for the Falcon 9 too, and nobody knows how many gremlins remain to be flushed out of the Falcon 1 design, because they didn't get to test much of the vehicle.
If each stage carries a full load of LOX but only enough kerosene for about 100 m/s delta-V, we should get a short, locally recoverable hop, without the need for an intercontinental missile range. A set of large floats attached to the tail of the rocket might keep the engine from a complete dunking on splashdown, if that is perceived to be a problem. The lack of a range is a huge deal -- they could have done quite a bit of flight testing in parallel with getting onto Kwaj, and my guess is they're going to need plenty of launch experience before Vandenberg will let them launch there.
So the test plan, then, would be to launch two or three rockets perhaps a dozen or more times from a small island in the middle of a small uninhabited lake in the continental United States. Start by launching single stages by themselves (first and second), and then move on to two stage launches. I've read that Wisconsin wants to have a spaceport, perhaps they'd be willing to cough up the necessary permits.
While short hops are not going to test the vacuum and high-speed portions of the flight, they will test all sorts of other good stuff, many of which were tested for the first time at Kwaj (where it was more expensive):
I'll stop here, the list is endless. The point is that a lot of confidence can be built doing cheap flight tests away from the U.S. Government's test range.