Dang, been ages since I played DW2. If you get the chance upgrade to Dynasty Warriors 7, you'll literally be blown away by the graphical updates, the much more accurate historical timeline for the battles (as DW2 was missing some key ones due to time restraints when they made it) and the nearly doubled character total.
As to the problem, yes Free mode does enhance characters in Musuo mode, however, certain characters need to be unlocked via Musuo mode to get the characters for free mode.
So taking Shu for an example to unlock all the characters it is...
Huang Zhong, Ma Chao, and Jiang Wei - Finish one Shu scenario
Zhuge Liang - Complete all Shu's starting character scenarios
Liu Bei - Clear Musou Mode with every Shu character
Also an easy one to miss when you first play is...
Lu Bu - Score at least 1,000
KOs at Hu Lao Gate; can also be done in free mode
Oddly Yellow Turbans on that
lvl has always been one of my fave
lvls over all the Dynasty Warriors games, so I was very happy when they updated it as a DLC for DW7.