I think I found a solution. It would probably work for others.
I split the loader into two separate HTML files: one that uses XMLHttpRequest to get all the required files and put them in localStorage (the loader) and another that simply reads the files from localStorage and writes them into the document (the booter) with appropriate wrappers (e.g. ). The booter has a manifest file to keep it in the application cache. The loader does not. The user first invokes the booter. If the booter finds files already in localStorage it does it's thing. Otherwise, it uses location.replace() to invoke the loader. The loader loads the files from the server using XMLHttpRequest and puts them in localStorage, and then re-invokes the booter using location.replace(). This seems to not cause an network error.
In order to run offline, the user must invoke the booter in the iPhone Safari browser (which invokes the loader, which re-ivokes the booter) which boots the WebApp. In Safari, the user must then add the WebApp (the booter link) to their Home Screen (using the "+" button at the bottom). When offline the user can get to the app from the Home Screen icon. It takes a few seconds to re-render, but it's fully functional after that. It's the same delay when online. Invoking the link from the iPhone Safari browser will not work offline, though it will work online.
The booter monitors the application cache's "updateready" event so that when online and the when iPhone detects a change in the booter's manifest file and downloads a new booter, it will swap the new cache (window.applicationCache.swapCache()) and invoke the loader using location.replace() again. I also add an alert() to let the user know something funky is going on. So changing the manifest file (I mean making some bytes different, not just tweaking the modify time) will cause clients to get new files when online.
Interestingly, I noticed that localStorage set up in Safari is not available to the same page served from invoking the Home Screen icon, even though the cookies transfer! So the first time the booter is invoked from the icon it will reload the files even though they were previously loaded in Safari. Also, I had to explicitly prevent the loader from being cached as it was not reloading from the server when the rest of the files were updated.