I cannot reproduce it.

Do you have the bag only with faults?
Doesn't it occur if you just return string with special characters?

May be the bug is related to ext/mbstring. Try to set mbstring.http_input and mbstring.http_output to "pass".

I set up a new test with XAMPP Lite 1.7.0 (Apache 2.2.11 + PHP 5.2.8).
The following 3 files are located in: http://localhost/soap/

Here my soap-server (index.php)
------------------------------------------------------------
<?php
require('SoapFaultTest.php');

$server = new SoapServer(null, array('uri' => 'http://localhost/soap/', 'encoding' => 'ISO-8859-1'));
$server->setClass('SoapFaultTest');

try {
	$server->handle();
} catch (Exception $e) {
	$server->fault("Sender", $e->getMessage());
}
?>


My service class (SoapFaultTest.php)
------------------------------------------------------------
<?php
class SoapFaultTest
{
    public function test() {
    	//  Test #1
        return 'Test #1 exception with some special chars: ???';
        
        //  Test #2
        //throw new Exception('Test #2 exception with some special chars: ???');
    }
}
?>


And my soap-client (client.php)
------------------------------------------------------------
<?php
try {
    $client = new SoapClient(null, array(
		'location'	=> 'http://127.0.0.1/soap/index.php',
		'uri'		=> 'http://127.0.0.1/soap/',		
		'encoding'	=> 'ISO-8859-1')
	);    
    echo $client->test();
}
catch (SoapFault $fault) {
    echo 'Error: ' . $fault->getMessage();
}
?>


Getting test-results by http://localhost/soap/client.php:

Test #1 - result as expected:
Test #1 exception with some special chars: ???

Test #2 - result:
Error: SOAP-ERROR: Encoding: string 'Test #2 exception with some special chars: \xc4...' is not a valid utf-8 string

Test #2 - expected:
Test #2 exception with some special chars: ???

SoapServer->fault() ignores the encoding!
Hope you can now reproduce the bug.

This bug has been fixed in SVN.

Snapshots of the sources are packaged every three hours; this change
will be in the next snapshot. You can grab the snapshot at
http://snaps.php.net/.
 
Thank you for the report, and for helping us make PHP better.