I have a web service from which I need to return a string containing html. This html is the markup for a Select control (for use in jqGrid search filters), e.g.
I assume you use it through Javascript.
If you do an unescape(response), your problem should be solved.
On the other hand, if you don't use it in Javascript but just in a ASP.NET / PHP / whatever website you are probably better off by just returning an array of values and display values, so that you can reuse the webservice in other code.
Your piece of code now only works in an HTML environment. What if you need to write a .NET / C++ / whatever app tomorrow that utilizes your webservice? Then you'll need to change it. And that is not the point of webservices. Webservices promote reusability of code. And you are fighting against that. (and the code will win!)