In the Microsoft "schema" test set, test

   <test group="schU1" name="schU1"/>

there are two schema documents, each of which redefines the other. The metadata indicates that this is considered valid.

I can't find an explicit ban on circular redefines. However, I believe there is an implicit ban. XML Schema Part 1 Schema Representation Constraint: Redefinition Constraints and Semantics states:

If the ·actual value· of the schemaLocation [attribute] successfully resolves [then] it resolves to [something which] corresponds to a <schema> element information item in a well-formed information set, which in turn corresponds to a valid schema.

In the presence of circular redefines, I don't believe that this rule is decideable. You can't determine whether the information set corresponds to a valid schema without processing the xs:redefines, and this leads to infinite regress.

(Perhaps this is wriggling. The same argument could be used to disallow circular xs:include. However, it's relatively easy to find an algorithm for determining that either all the xs:include directives in a cycle are valid, or none of them are. Because of the special semantics of xs:redefine, it's far less clear that such an algorithm exists in this case.)