Instance blocking is just blocking all communities on that instance, unfortunately.

Like Blaze said, you can try Piefed (LW also operates a Piefed instance) or you can use an alternate UI for Lemmy that does hide users from blocked instances. Not sure which do except Tesseract (t.lemmy.world) since I wanted to be able to do the same thing.

The setting for that is under Settings -> Filtering -> Hide Users From Blocked Instances