What XSLT processor are you using?
The serializer should never output numeric character references (like & #65535; [I think ampersands are getting lost in this forum]) within a CDATA section, because XML doesn't recognize them there. This looks like a bug in your processor.
Secondly, Unicode 65533 is a substitute character for use when a character is found that can't be output in the selected encoding. If the selected encoding is UTF-8, I can't see any reason why it would be used.
The first thing to check is that your input XML is correctly encoded. What is the actual encoding of the c-with-cedilla (use a hex editor to find out), and what is the encoding specified in the XML declaration of the input file? Do they match?
Michael Kay
http://www.saxonica.com/
Author, XSLT Programmer's Reference and XPath 2.0 Programmer's Reference