//item[category/.='Featured']
is not even syntactically valid XPath, I assume that is a typo.
In any case, this is not about CDATA. CDATA is meaningless, it does not exist. It only matters during parsing of a document. When you get to use XPath on the input it is already gone.
You need to trim whitespace before you make string comparisons. Try:
<xsl:apply-templates select="//item[category[normalize-space() = 'Featured']]" />