See Description Note of parent CR 5064280.
Note: I cannot find the original description, since Bugster just says

"See Description Note of parent CR 5064280."

so I am assuming that I originally filed this about supporting

<xsl:output method="xml" indent="yes" xalan:indent-amount="4" xmlns:xsl="http://www.w3.org/1999/XSL/Transform" xmlns:xalan="http://xml.apache.org/xslt"/>

which does in fact seem to work fine in both 1.5.0_04 and Mustang b45. I.e. this works:

String xslt =
        "<xsl:stylesheet version='1.0' " +
        "xmlns:xsl='http://www.w3.org/1999/XSL/Transform&#39; " +
        "xmlns:xalan='http://xml.apache.org/xslt&#39; " +
        "exclude-result-prefixes='xalan'>" +
        "<xsl:output method='xml' indent='yes' xalan:indent-amount='4'/>" +
        "<xsl:template match='@*|node()'>" +
        "<xsl:copy>" +
        "<xsl:apply-templates select='@*|node()'/>" +
        "</xsl:copy>" +
        "</xsl:template>" +
        "</xsl:stylesheet>";
Transformer t = TransformerFactory.newInstance().newTransformer(new StreamSource(new StringReader(xslt)));
t.transform(..., ...);

but this does not:

Transformer t = TransformerFactory.newInstance().newTransformer();
t.setOutputProperty(OutputKeys.INDENT, "yes");
t.setOutputProperty("{http://xml.apache.org/xslt}indent-amount", "4");
t.transform(..., ...);

Newlines are printed but no indentation, despite the output property.