DNSmasq 'Do not use system DNS servers' issue

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Hello,

I'm having a strange (I think) issue with DNSmasq. If I set it up to use the servers listed in System/General Settings, everything works perfectly: I can go out to the internet and resolve local hostnames (as defined by the host overrides).

However, if I enable 'Do not use system DNS servers' and insert 'server=<dns server ip>' (using the same server that I would put in System/General Settings), I can still go out to the internet but I lose local hostname resolution despite host overrides being defined. Is this expected behavior?

Thanks