I too prefer either the Hendrix or Dylan versions, of course, but the podcast (by Ronald Moore) for that episode explained it pretty well for me - he basically said that according to the mythos they're developing, it makes sense for there to be a song 'All Along The Watchtower' identical to the one we have...but for Hendrix (or Dylan) to be singing it wouldn't make sense, since there wouldn't be a Hendrix or Dylan in the BSG universe.
Ok, it's a bit of a stretch, but at least it's an explanation.
http://www.scifi.com/battlestar/downloads/pod