> or is it better to use saxon:assign for that?

It's never better to use saxon:assign, assigning to variable references
in this way completely breaks the processing model of xslt.

> My initial approach was to simply use <xsl:number/>
what was wrong with that approach?
It would seem that you just want


xsl:stylesheet xmlns:xsl="http://www.w3.org/1999/XSL/Transform"  
version="1.0">

<xsl:template match="*">
  <xsl:copy>
    <xsl:copy-of select="@*"/>
    <xsl:apply-templates/>
  </xsl:copy>
</xsl:template>

<xsl:template  match="group">
   <xsl:copy>
    <xsl:copy-of select="@*"/>
    <xsl:attribute name="number"><xsl:number/></xsl:attribute>
    <xsl:apply-templates/>
  </xsl:copy> 
</xsl:template>

<xsl:template  match="item">
   <xsl:copy>
    <xsl:copy-of select="@*"/>
    <xsl:attribute name="number"><xsl:number count="group|item" level="multiple" format="1-1" /></xsl:attribute>
    <xsl:apply-templates/>
  </xsl:copy> 
</xsl:template>


</xsl:stylesheet>



$ saxon num.xml num.xsl
<?xml version="1.0" encoding="utf-8"?><top>
    <group number="1">
        <item number="1-1">test</item>
        <item number="1-2">test</item>
        <item number="1-3">test</item>
        <item number="1-4">test</item>
    </group>
    <group number="2">
        <item number="2-1">test</item>
 <otheritem>test</otheritem>
        <item number="2-2">test</item>
        <item number="2-3">test</item>
        <item number="2-4">test</item>
    </group>
</top>




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