I have probably seen a half a dozen article submissions to MSDN in the last year with authors who do the following:

// Bad Bad Bad
[WebMethod]
public string MyLameWebMethod()
{
    XmlDocument dom = new XmlDocument();
    // load some XML ...
    return dom.OuterXml;
}

and then on the client side they do this:

// Bad bad bad
localhost.Service1 proxy = new localhost.Service1();
XmlDocument dom = new XmlDocument();
dom.LoadXml(proxy.MyLameWebMethod());

!!!DON'T DO THIS!!!

Try this instead:

// Better
[WebMethod]
public XmlDocument MyBetterWebMethod()
{
    XmlDocument dom = new XmlDocument();
    // load some XML ...
    return dom;
}

Then the client will look like this:

// Better
localhost.Service1 proxy = new localhost.Service1();
XmlNode xml = proxy.MyBetterWebMethod();

Now you are avoiding an added level of serialization/deserialization.  This applies to valid XML only!!  Non-wellformed HTML should be passed as a string that is HTML encoded.

I will say that I have sympathy about this sort of thing and the tools often aren't much help, but if I can help it, MSDN will never have an article encouraging users to pass XML as an encoded string to/from a Web service.

By the way, I've been trying to think of a scenario where returning XML as a string to/from a Web service might make sense...without luck.  If you have one, I would like to hear about it.  I think it is safe to say that for the vast majority of situations, returning XML as an encoded string is not a good practice.

   -Matt