I'm using Project 2007 and I am working on a project plan where I have a resource available 1.5 hrs / day (so have set their "max. units" at 12.5% to represent this). Some of the tasks in the plan are over 1.5 hrs however (e.g. 3hrs), so when I try to do automatic resource leveling Project complains that 3hrs is > 1.5hrs and won't do it. What I want it to do is realize that the 3hr task will take two 1.5 hr days. I don't want to artificially break down 3hr tasks into two 1.5hr tasks either.

How do I get resource leveling to work like this?

Max units isnt really the way to do this. set up a calendar that allows 1.5hrs/ day and apply it to your resource, and that should cure the problem.
The difference is that max units is not a true limit- you can have a situation where your actual units are greater, whereas with a calendar it is not possible to work outside of the assigned limits.
hope that helps.

Thanks, custom calendar worked great.