This is a classic for-each-group example:


<xsl:stylesheet version="2.0" xmlns:xsl="http://www.w3.org/1999/XSL/Transform">
  <xsl:template match="section" name="group">
    <xsl:param name="s" select="section"/>
    <xsl:param name="l" select="1"/>
   <xsl:for-each-group select="$s" group-starting-with="*[@level=$l]">
     <section id="{@id}">
       <xsl:call-template name="group">
	 <xsl:with-param name="s" select="current-group()[position()!=1]"/>
	 <xsl:with-param name="l" select="$l+1"/>
       </xsl:call-template>
     </section>
   </xsl:for-each-group>
  </xsl:template>
</xsl:stylesheet>


 saxon8 fl.xml fl.xsl \!indent=yes
<?xml version="1.0" encoding="UTF-8"?>
<section id="1">
   <section id="1-1"/>
   <section id="1-2">
      <section id="1-2-1"/>
      <section id="1-2-2"/>
   </section>
</section>
<section id="2"/>


David