Their option is dead wrong. But your option may be failing because they might be doing DTD validation and I don't know enough DTD language to be sure that it's right. There's a condition that might mean that li elements can contain EITHER block content (div, p etc.) or inline content (plain text, span, label, b, i, em, a etc.) but not both.

http://www.w3.org/TR/html4/sgml/dtd.html

states:

<!ENTITY % flow "%block; | %inline;">
...
<!ELEMENT LI - O (%flow;)* ...

The dash and the O means that the opening LI tag is required and the closing is optional. That seemss ambiguous depending on your SGML parser's behaviour and how it treats the binding there. As I say, I don't speak DTD or SGML well enough, but that could be interpreted as "any number of either-block-or-inline elements" or "either any number of block elements or any number of inline elements."

The schema also may be tight: http://www.w3.org/2002/08/xhtml/xhtml1-strict.xsd creates a complexType called Flow which can be any one of four choices. I think choice means it has to be a single one of them, but then that one can occur multiple times. So multiple elements from the block or inline groups, but not a mixture.

Try wrapping everything within the LI in a DIV and see where that gets you.