You need to parse the string containing the XML and turn it into a tree of nodes. This is best done from your C# code, by invoking the XML parser. You should then pass the resulting XmlDocument node to the transformation. It's then already a nodeset (a set containing one node) so you don't need to invoke any extension functions.
Conversion of lexical XML to a tree (that is, parsing) never happens automatically, it only happens when you ask for it.
Author, XSLT Programmer's Reference and XPath 2.0 Programmer's Reference