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If the Search Engine was to crawl the HTML it would see those three characters as ö, ø and å respectively.
I know that the majortity of people using search in Sweden use the special characters when performing a search query, but i'm not sure how the special characters are processed by the search engines.
For Example, if a user was searching for Malmö, could I use either Malmö or Malmö for keywords, would it make a difference, I guess it would to some extent as Malmö in my HTML reads like Malmö. I guess I could go in the HTML and change Malmö to Malmö, but I hear this is not good practice.
If anyone has any input on this I would really appreaciate it.
Here's a related (short) thread: Accessibility issues with foreign characters in folder names [webmasterworld.com].
My personal preference is to encode the site as UTF-8 and use the accented character rather than the entity reference, but if you stick to ISO-8859-1 and use entity references throughout you won't have any problems either, other than the slight increase in page weight.
I avoid using anything other than US-ASCII filenames (page names) as anything outside this range is URL-encoded for transmission - so use the non-accented character instead for page names.
Viewing the source from the top 3 results for malmö (and looking for malmö or malmö or malmo). I found the following text occurences at the top of the page -
1) malmö malmö malmö malmö malmö
2) malmö malmö malmo malmö malmö malmö malmö
3) malmö malmö malmö malmö malmö
If the swedish do search for malmö it seems from that google favours its use on page but you might want to look a bit deeper than I did and of course consider other popular Swedish SE's.