Raymond Tallis has a short piece in Philosophy Now: "Zhuangzi and that Bloody Butterfly." 
He finds the classic anecdote annoying and he sets out to undermine
it.  His central argument is that the radical skepticism which suggests
we cannot distinguish between a dreaming and a waking state fails
because, ultimately, the audience comes to assume that there really was
a philosopher named "Zhuangzi" and that he was awake often enough to
produce the book (or at least the ideas) that we ascribe to him:

…The viewpoint is decisively his, and there is an undeclared assumption
that the story is being told from outside of the dream, and indeed
outside both the sage’s waking and dream states so that they can be
compared and the pretence of equivalence teasingly advanced. What’s
more, there is another, larger outside-of-a-dream, which situates the
dream of being a butterfly as a dream – namely, the public to
whom the story was addressed, and those later publics to whom it has
been passed on over all those hundreds of years. At any rate, the
difference between dreaming and waking is upheld, and whatever
Zhuangzi’s professed doubts about his own nature, we do not
doubt that he was a philosopher who lived at a certain time, and that
he told an anecdote intended to justify doubting his own nature.
Irrespective of whether the philosopher could or could not adjudicate
between the two views on his nature, we don’t hesitate to do so. We are
confidently outside his dream and, in the space of shared history,
outside of our own dreams too. 

And
there you have it.  But I think this misses Zhuangzi's point.  The
Daoist is not positing an absolute distinction between dream and
reality.  Indeed, the butterfly anecdote is found in Chapter 2 of the
Zhuangzi book, the chapter in which the author rejects the efficacy of
any analytic distinctions.  Rather, the point is to raise doubt about
the certainty we attach to knowledge generated from strictly drawn
distinctions.  We cannot know for sure.  And instead of constructing
ways of knowing that rely upon artificial (and by that I mean "suited
to the purposes of the knower instead of the conditions of the things
to be known") distinctions, Zhuangzi is advocating for a more holistic,
open-ended, dynamic and fluid way of knowing.

Tallis seems to realize this.  He does not throw the butterfly out with the bathwater:

…Even so, it is not entirely without merit. It reminds us that when we
engage in philosophical inquiries fuelled by radical doubt, we often
overlook the very context that is necessary for the inquiry to take
place, which has to be untouched by doubt. In the case of the Daoist
story, the historical record is also left intact, in addition to the
community of discourse to which we, the waking, assume we belong. And
this shows that the doubt that is being raised – that we never know
whether we are or are not dreaming – is not really being
entertained. We only imagine that we are entertaining it; or, to put it
another way, our language takes us to a place we cannot actually
inhabit. This is in addition to the fact that we don’t give much house
room to radical doubts when we are hungry or worried over a child with
a temperature or feeling a chump or even just running for a bus.

Yes,
there are limits to doubt.   And Zhuangzi recognizes this.  After all,
he (or someone who was advancing his ideas) wrote a text in beautiful
prose and circulated it.  A truly radical skeptic, one who accepted the
incapacity of language to capture the fullness and complexity of Way,
would not bother to write and publish.  How could he or she be sure
that the meaning of the words would persist long enough for such a text
to make any sense at all?  But Zhuangzi is not that radical.  He's
radical – he doubts the possibilities of language long before
Wittgenstein and company – but he also knows he exists in the world.

The
problem, then, is how do we exist in the world?  Zhuangzi, and other
skeptics, believe that certainty, or over-certainty, creates more
problems in the world than doubt, or over-doubt.  That is why he
advances skepticism: to counteract the myriad distortions and damage
done by over-certainty in the world.  Think of the pain and suffering
caused by the definition and defense of absolute notions of right and
wrong, or of the anxiety produced by the prospect of crossing the line
from life to death.  That is what Zhuangzi is warning us about.  He is
not an absolute skeptic; rather, he is a strategic one, intervening in
the world as it is in an attempt to get us to back away from stubborn
adherence to distinctions that cannot capture the intricacies of Way or
even of the human experience in Way.

Let's leave it with some other words from Chapter 2 of Zhuangzi:

We set out
like ingenious machines declaring "yes this" or "no that."  Or we hold
fast like oath-bound warriors defending victory.

We can say
that to fade away day by day is to die like autumn into winter.  But
we're drowning, and nothing we do can bring any of it back.  We can say
this drain is backed up in old age, full and content, but a mind near
death cannot recover that autumn blaze.

Joy
and anger, sorrow and delight, hope and regret, doubt and ardor,
diffidence and abandon, candor and reserve: it's all music rising out
of emptiness, mushrooms appearing out of mist.  Day and night come and
go, but who knows where it all begins?  It is! It just is!  If you
understand this day in and out, you inhabit the very source of it all.