I don't know the details of System.Xml.Xsl, but by analogy with other APIs I imagine that if you use a method like
public XmlReader Transform(XPathNavigator, XsltArgumentList, XmlResolver);
then the result isn't going to be serialized and disable-output-escaping is likely to have no effect.
Michael Kay
http://www.saxonica.com/
Author, XSLT Programmer's Reference and XPath 2.0 Programmer's Reference