Certainly:

<xsl:stylesheet version="2.0" xmlns:xsl="http://www.w3.org/1999/XSL/Transform" xmlns:xs="http://www.w3.org/2001/XMLSchema" xmlns:fn="http://www.w3.org/2004/07/xpath-functions" xmlns:xdt="http://www.w3.org/2004/07/xpath-datatypes">
    <xsl:output method="xml" version="1.0" encoding="UTF-8" indent="yes"/>

<xsl:variable name="filters">
  <filter text="target" replace="objective"/>
  <filter text="anywhere" replace="somewhere"/>
  <filter text="hi" replace="hello"/>
  <filter text="secret" replace=" "/>
</xsl:variable>

<xsl:template name="filter">
<xsl:param name="str"/>
<xsl:choose>
  <xsl:when test="$filters/filter[contains($str, @text)]">
    <xsl:variable name="match" select="$filters/filter[contains($str, @text)]"/>
    <xsl:variable name="word" select="$match/@text"/>
    <xsl:variable name="repl" select="$match/@replace"/>
      <xsl:call-template name="filter">
      <xsl:with-param name="str">
        <xsl:value-of select="substring-before($str,$word)"/>
        <xsl:value-of select="$repl"/>
        <xsl:value-of select="substring-after($str,$word)"/>
      </xsl:with-param>
    </xsl:call-template>
  </xsl:when>
  <xsl:otherwise>
    <xsl:copy-of select="$str"/>
  </xsl:otherwise>
</xsl:choose>
</xsl:template>

<xsl:template match="/">
<xsl:call-template name="filter">
  <xsl:with-param name="str" select="self::text()"/>
</xsl:call-template>
<xsl:apply-templates/>
</xsl:template>

<xsl:template match="@*|*">
    <xsl:copy>
        <xsl:apply-templates select="@*|node()"/>
    </xsl:copy>
</xsl:template>

</xsl:stylesheet>

I looked at the template 'filter' and everything made sense to me as to what it was matching against and replacing. The only thing that I could think of was that it was actually looking at the values of the attributes. Could the problem be with having multiple elements within a global variable, and/or trying to match against their attributes? I added some text in the $filters/filter elements to see some things. For example:

<xsl:variable name="filters">
  <filter1 text="target" replace="objective">word1</filter1>
  <filter text="anywhere" replace="somewhere">word2</filter>
  <filter text="hi" replace="hello">word3</filter>
  <filter text="secret" replace=" ">word4</filter>
</xsl:variable>

<xsl:variable name="longfilters">
    <filter1>
        <text>target</text>
        <replace>objective</replace>
    </filter1>
    <filter>
        <text>anywhere</text>
        <replace>somewhere</replace>
    </filter>
    <filter>
        <text>hi</text>
        <replace>hello</replace>
    </filter>
    <filter>
        <text>secret</text>
        <replace>Secret</replace>
    </filter>
</xsl:variable>

<xsl:template name="filter">
************output******************
(1)<xsl:value-of select="$filters"/>
(2)<xsl:value-of select="$filters/filter1"/>
(3)<xsl:value-of select="$filters/filter/@text"/>
(4)<xsl:value-of select="$filters/filter,@text"/>
(5)<xsl:value-of select="$longfilters"/>
(6)<xsl:value-of select="$longfilters/filter"/>
(7)<xsl:value-of select="$longfilters/filter/text"/>
(8)<xsl:value-of select="$longfilters/filter1/text"/>
***********end output***************
</xsl:template>

<xsl:template match="/">
<xsl:call-template name="filter"/>
<xsl:apply-templates/>
</xsl:template>

and the output that I get is:

************output******************
(1)word1 word2 word3 word4
(2)
(3)
(4)
(5)targetobjective anywheresomewhere hihello secretSecret
(6)
(7)
(8)
***********end output***************

downloaded a trial copy of xmlspy2005 yesterday.
XMLSpy 2005 seems to be inconsistent with XMLSpy 2004... I've a working copy for Saxon 8, but it seems to be incompatible with XMLSpy 2005.
working on it now,..
--
Saxon 8 compatible version:
Changes:Only replaces text nodes.
filter variable changed back, because of difference in interpretation of xslt spec.
MSXML version:
change the match variable to:
<xsl:variable name="match" select="msxml:node-set($filters)/filters/filter[contains($str, @text)]"/>
add the xmlns namespace to the stylesheet:
xmlns:msxml="urn:schemas-microsoft-com:xslt"
and change the version back to 1.0

I tend to think there's a bug in Altova's XPath 2.0 processor.

Wow. That works very well! Thank you so much for all of your help,... much appreciated!

~Ryan