I know trained musicians who can sight play anything, yet always seem to me to have left their ears at home when they play.
Music without hearing is a dead thing. Too much of it can bring about the worship of mere velocity as if it were virtuosity, but that's another subject for another rant.
Leeneia, Tigger, I think "playing by ear," done well, is an awesomely complex process. As you explore your instrument, and try to internalize the music you are emulating, you develop an astoundingly powerful network of mental and physiological tools, that all come to bear together mostly beyond conscious effort. There is a visual component, a motor memory component, an aural memory component, a cognitive component, an emotional component, and certainly other things I can't think of right now.
I do believe that this menagerie of skills is necessary to truly make music, much more than the ability to accurately bash keys in response to the flow of dots on a page, like a player piano.
My own reading skill has always lagged behind the other skills, too. One obvious disadvantage has been the inability to quickly pick up a new piece from written music. Another one, not so obvious, is that you become limited in your comprehension of music to that which you already have been exposed to, and understand.
If you have access to a mentor you can learn something new, but you are still limited to the scope of the mentors you can find (and induce to spend enough time with you).
But with the ability to read music (don't have to be a sight-playing wizard, either) you can branch out and explore things that your "ear" skills can't quite bring you to.
-Glenn