set_content() handles XML entities differently, depending on context. Take a look at following example:

<?php
$xml = domxml_new_doc('1.0');
$root = $xml->append_child($xml->create_element('root'));
$root->set_content('&#160;');
$root->set_content('&#160;');
echo $xml->dumpmem();
?>

It produces following document:

<?xml version="1.0"?>
<root>&#160;&amp;#160;</root>

 Note, that first entity was determined as entity, but second - as plain text, and hence quoted. Problem is in php_domxml.c, function domxml_node_set_content(), around line 2734 (as for version) 1.218.2.23:

if (nodep->children) {
	xmlNodeAddContentLen(nodep, content, content_len);
} else {
	xmlNodeSetContentLen(nodep, content, content_len);
}

 If you'll take a look into source of these functions in libxml (file tree.c) - you will see, that xmlNodeSetContentLen() parses given content for entities, while xmlNodeAddContentLen() - not.