At the end of your template, add an <xsl:apply-templates /> directive to instruct the processor to repeat the match, but on the current node set (i.e. first it passes through inventory/item s, then it will pass through the inventory/item/item s. ).

Your code has extraneous </strong> tags which I'll conveniently ignore. Here's a quick-and-dirty set of templates that will generate the output you're after:

<!-- create an unordered list with the class attribute value of "inventory" for each "inventory" element -->
<xsl:template match="inventory">
<ul class="inventory">

<!-- process the "item" child elements of inventory -->
<xsl:apply-templates select="item" />

</ul>
</xsl:template>

<xsl:template match="item">
<!-- create a list item for every "item" element -->

<li>
<!-- does the "item" have an "equipped" attribute whose value is true? if so, create a class attribute on the li with the value "equipped" -->

<xsl:if test="@equipped='true'">
<xsl:attribute name="class">equipped</xsl:attribute>
</xsl:if>

<!-- does the "item" have a "type" attribute whose value is not null? if so, insert the value of "type" in the src attribute of the img -->
<xsl:if test="@type!= ''">
<img src="{@type}.gif" />

<!-- does the "item" have an "ammount" attribute whose value is greater than one? if so, insert the value of "ammount" and some text -->

<xsl:if test="@ammount &gt; 1">
<xsl:value-of select="@ammount" />
<xsl:text> &times; </xsl:text>
</xsl:if>
</xsl:if>

<!-- insert the "name" of the "item" -->

<xsl:value-of select="@name" />

<xsl:if test="item">
<!-- if the "item" has child items, create a new list and start over again -->

<ul>
<xsl:apply-templates />
</ul>
</xsl:if>

</li>
</xsl:template>