The latest I can find from the web and blogosphere indicate that Microsoft's XML team would be supporting XSLT 2.0 (now that it was a full blown W3C recommendation). I can't find anything beyond that.
What's the current status? Is it available in .NET 3.5 or are they stuck with XSLT 1.1 and pushing XQUERY and LINQ?
It is not supported by Microsoft and there hasn't been any anouncement I'm aware of. Where did you hear about that?
It seems that Microsoft changed their strategy according to this interview with Chris Lovett, a Program Manager on the XML team at Microsoft, later the same year, so it's all about LINQ:
As for XSLT 2.0 - we’ve heard from customers and understand the improvements in XSLT 2.0 over XSLT 1.0, but right now we’re in the middle of a big strategic investment in LINQ and EDM for the future of the data programming platform which we think will create major improvements in programming against all types of data. But we are always re-evaluating our technology investments so if your readers want to ramp up their volume on XSLT 2.0 please ask them to drop us a line with their comments.
If you want to use XSLT/XPath 2.0 with .NET you could use Saxon.NET. However, this is just the Java version of Saxon running inside IKVM. It has a significant size in the range of 30 MB and when I tried it the performance did not seem overwhelming (This was a very basic test though so the result might be different with a typical stylesheet).