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 3.5/4.0 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?
UPDATE (after you added the link to the XML Team Blog):
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:
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).
XQSharp now includes a full XSLT 2.0 implementation for .NET. It doesn't yet compile to MSIL, but that is in the pipeline.