Same code as me basically. When I step through in debug mode and break at what would be your textbox1.Text = Editor1.XHTML and hover over XHTML, I get the incorrect one. As a matter of fact, it looks like it has been encoded twice already:
<!-- &nbsp; --> for example. I just put in the text and submit and that's what I get.
On your demo somewhere there was a comment about choosing between encoding formats HTML1 or something. Where is that? Would that be related?