Rather than a rails/mongrel problem, it sounds more likely that there's an issue either with your XML file or with the way REXML handles it. You can check this by writing a short script to read your XML file directly (rather than within a request) and seeing if it still fails.
Assuming it does, there are a couple of things I'd look at. First, I'd check you are running the latest version of REXML. A couple of years ago there was a bug (http://www.germane-software.com/projects/rexml/ticket/63) in its UTF-16 handling.
The second thing I'd check is if you're issue is similar to this: http://groups.google.com/group/rubyonrails-talk/browse_thread/thread/ba7b0585c7a6330d. If so you can try the workaround in that thread.
If none of the above helps, then please reply with more information, such as the exception you are getting when you try and read the file.