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The XSL WG reviewed the resolution of XQuery bug http://lists.w3.org/Archives/Member/w3c-xsl-wg/2006Sep/0082.html and decided to adopt the same resolution for XSLT: if a stylesheet attempts to write an xml:space attribute with a value other than "space" or "default", the processor MAY signal an error. (It was noted that some XML parsers treat this as an error, and the XML spec allows them to do so.)
Spec now updated.