Why are you converting charset in the first place?  Doesn't expand work in
UTF-8?  If so, that's the real bug.

Created attachment 113419 [details]
Test file

The charset conversion here is just for the purpose of providing a oneliner
that easily reproduces the bug.

The full practical reproducer is:

- I have some source code that contains non-ASCII ISO-8859-1 accented 
  characters.  ISO-8859-1 is fine for these files, and must not be changed.
- I want to convert spaces to tabs in those files using unexpand.
- When I run unexpand on these files, the spaces get converted to tabs as 
  expected, but as a side effect, all the ISO-8859-1 accented chars turn into
  gibberish.

Please also note that it's unexpand(1) that has the bug.  Not expand(1), it
seems to be doing the right thing.

Try it out with the attached file:

  gunzip 155382.txt.gz
  unexpand 155382.txt > test.out
  # compare 155382.txt and test.out, they should be equivalent, but are not

Works fine here, when the locale is set correctly.  Your test case is incorrect,
and should be using 'LC_CTYPE=en_US unexpand' as in:

$ echo $LANG
  en_US.UTF-8
  $ echo Skyttä \
  | iconv -f utf-8 -t iso-8859-1 \
  | LC_ALL=en_US unexpand \
  | iconv -f iso-8859-1 -t utf-8

Otherwise unexpand will be expecting UTF-8 input.

Well, I still think this is a bug because unlike unexpand, expand is doing the
right thing, not changing anything but the spaces or tabs without any LC_*
environment fiddling in this case.

Reopening based on that.  If you disagree, I'd like to hear why expand and
unexpand are expected to behave differently regarding these accented characters
with the same environment settings and same input.

No, you *must* set the encoding correctly, otherwise all bets are off.

You can't expect expand or unexpand to be able to do their job if they cannot
make sense of the input.  Garbage in, garbage out.