The distribution is assumed with respect to the error terms.

Another way of saying this is that the distributions of the Ysconditional on the X valuesis normal.

The conditional distribution of the Ys may indeed be normal despite the marginal distribution not being normal. A group of us from the forum wrote a paper on regression assumptions in which we used a simple simulation showing a situation like this: http://pareonline.net/getvn.asp?v=18&n=11