Sounds like the Lit file is corrupted in some way - probably some incorrectly encoded non-breaking-space based on that entity error, but the earlier complaint about the missing <head/> element indicates there are probably other problems.
I would say there are two options:
- Use Calibre's debug output (under the conversion options) to see if you can get the initially extracted html, repair it by hand, and add back to Calibre
- Use ConvertLit to extract the html, again repair what's wrong, and add the corrected html back to Calibre
If neither option works you've probably just got a hopeless Lit file - it happens.