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Interesting that your test worked - guess I either have a different version of writer2xhtml or I didn't set it up right.
As a workaround you can use the writer2xhtml option so that named entities are used, and then you can create a Save Search group to replace each named entity with the actual character (e.g. replace &eactute; with é). Not ideal, but until there is a fix it seems the best option.
The entity will always show up in Code View, even if this issue is fixed. This is because if the nbsp character is used, the Qt based Book View would incorrectly convert it to a normal space.
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