Holodeck malfunctions were used so many times on TNG (and its successor series) that they became a cliche, but this is the very first -- and it's not bad.
Initially starting as a diversion for Picard (who is apparently as unfamiliar with the technology as the viewer), several crew members' lives become endangered once the holodeck stops functioning as intended. There's some genuine tension near the end -- a rarity in most season 1 episodes. Lawrence Tierney is great as the head mobster and his mildly annoying lieutenant (Leech) is very good too.
As far as the actual characters -- you can tell they are having great fun; lots of (somewhat uncharacteristic) flirting between Picard and Crusher, as well as lots of gags surrounding Data (he's from South America!). Gates McFadden was somewhat underused during the 1st season, but here she takes full advantage (particularly in the amusing makeup scene). And the final holodeck scene, with Picard's holographic friend pondering his existence, is actually poignant -- I'm surprised that the season 1 writers were capable of such a thing.
That said, it is not without its flaws. The "real world plot", involving protocol-obsessed insectoid aliens, is completely worthless. The writers completely overdo the Enterprise crew's lack of familiarity with 1930s Earth. And man... was it really necessary to have Wesley save the day yet again?