OK, I trimmed it down.  Unfortunately, I'm posting on Google groups, so
I can't attach files (maybe that's a no-no here anyway?).  So, here
goes:

First, the schema, which I have in a file BugSchema.xsd:
---------------BugSchema.xsd-----------------
<?xml version="1.0"?>
<xsd:schema xmlns:xsd          ="http://www.w3.org/2001/XMLSchema"
            targetNamespace
="http://lodl.ldc.upenn.edu/ParadigmDefn.xsd"
            xmlns
="http://lodl.ldc.upenn.edu/ParadigmDefn.xsd"
            elementFormDefault ="qualified"
>

    <xsd:element name="ParadigmDefns">
        <xsd:complexType>
            <xsd:sequence>
                <xsd:element ref="Paradigm"   minOccurs="1"
maxOccurs="unbounded"/>
            </xsd:sequence>
        </xsd:complexType>
    </xsd:element>

    <xsd:element name="Paradigm">
        <xsd:complexType>
            <xsd:sequence>
                <xsd:element ref="FeatureValueSet" minOccurs="1"
maxOccurs="unbounded"/>
            </xsd:sequence>
        </xsd:complexType>
    </xsd:element>

    <xsd:element name="FeatureValueSet">
    </xsd:element>
</xsd:schema>
-----------------------------------------------------------

Next, the file to be validated against that schema, Bug.Defn.xml:
------------------Bug.Defn.xml--------------------
<?xml version="1.0" encoding="ISO-8859-1"?>

<!DOCTYPE ParadigmDefn
    [<!ENTITY Inclusion SYSTEM "IncludeBug.xml">]
>

<ParadigmDefns xmlns
="http://lodl.ldc.upenn.edu/ParadigmDefn.xsd"
               xmlns:xsi
="http://www.w3.org/2001/XMLSchema-instance"
               xsi:schemaLocation="http://lodl.ldc.upenn.edu
ParadigmDefn.xsd"
>
        <Paradigm>
            <!--If the ff. '&Inclusion;' is commented out, this file
validates.-->
            &Inclusion;
            <FeatureValueSet></FeatureValueSet>
        </Paradigm>
</ParadigmDefns>
-----------------------------------------

And finally, the "include" file, IncludeBug.xml:
--------------------IncludeBug.xml---------------
<FeatureValueSet></FeatureValueSet>
-----------------------------------------

You'll notice that this line is identical to the line that appears
immediately below the '&Inclusion;'; the latter line does not cause any
problem, if the '&Inclusion;' is commented out.

The error msg happens (if the inclusion is not commented out) when I
run the ff. cmd:

  xmllint --noout --noent --schema BugSchema.xsd TestSuite/bug.Defn.xml

Specifically, the error msg is:

  Element 'FeatureValueSet': This element is not expected. Expected is
  ( {http://lodl.ldc.upenn.edu/ParadigmDefn.xsd}FeatureValueSet ).
  TestSuite/bug.Defn.xml fails to validate

I'm running this under CygWin.  xmllint reports "using libxml version
20622 of the in-memory document" (whatever that means--sounds like an
odd version #, but...)

Thanks for any suggestions!