Yes, the pfSense box is a DHCP and a local DNS server. While your suggestion did not work for me, I think I know what's wrong though. I connected to the network with my linux laptop and did some debugging. It turns out that the DHCP server passes some extra domain stuff to their DHCP clients upon registration. I did a cat /etc/resolv.conf file and got:
domain mydomain.com
search mydomain.com
nameserver 192.168.1.1
If I do a nslookup of an existing domain, it returns a proper IP address while doing the same for a non-existing domain i.e. www.somedomain.org returns www.somedomain.org.mydomain.com, and the IP is that of my router WAN interface. Manually removing the domain and search lines from resolv.conf seems to fix the problem. With nat reflection turned on I get proper errors now.
Now I just have to figure out how to fix the DHCP not to serve those domain lines.