diff --git a/lib/src/merged_tree.rs b/lib/src/merged_tree.rs
index 822663184..ceb61ce9a 100644
--- a/lib/src/merged_tree.rs
+++ b/lib/src/merged_tree.rs
@@ -739,10 +739,12 @@ impl<'matcher> TreeDiffIterator<'matcher> {
         } else {
             Merge::resolved(Tree::null(tree.store().clone(), dir.clone()))
         };
-        // We return a `MergedTree::Merge` variant here even if `self` is a
-        // `MergedTree::Legacy`. That's fine since we don't expose the
-        // `MergedTree` to the caller.
-        MergedTree::Merge(trees)
+        // Maintain the type of tree, so we resolve `TreeValue::Conflict` as necessary
+        // in the subtree
+        match tree {
+            MergedTree::Legacy(_) => MergedTree::Legacy(trees.into_resolved().unwrap()),
+            MergedTree::Merge(_) => MergedTree::Merge(trees),
+        }
     }
 }
 
diff --git a/lib/tests/test_working_copy.rs b/lib/tests/test_working_copy.rs
index 3d24568d1..f3c55a61a 100644
--- a/lib/tests/test_working_copy.rs
+++ b/lib/tests/test_working_copy.rs
@@ -271,8 +271,6 @@ fn test_checkout_file_transitions(use_git: bool) {
 
 // Test case for issue #2165
 #[test]
-// TODO(#2165): Shouldn't actually panic
-#[should_panic]
 fn test_conflict_subdirectory() {
     let settings = testutils::user_settings();
     let mut test_workspace = TestWorkspace::init(&settings, true);