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“Should the text inside the generated link be the URL itself?”
“If the block quote has a title attribute, how would you take its value and use it as the text inside the generated link?”
Using either the URL or the value of a title attribute would be better. Imagine a page with many blockquote elements, each with their own cite attribute citing a different source: then there would be many instances where the same link text (“source” in your example) points to different URLs. This would be bad from an accessibility point of view: think how the Links List would sound in a screen reader (“Source”, “Source”, “Source”, “Source”... with no context).
“Should the attribution paragraph be placed outside the block quote?”
It would be better if it were outside. First, because the attribution is not part of the quotation. Second, in a Note following section 9.2.2, the HTML 4.01 specification says that user agents should not insert quotation marks in the default style for the blockquote element. However, it also recommends that “style sheet implementations provide a mechanism for inserting quotation marks before and after a quotation delimited by BLOCKQUOTE”. If such an implementation were available and used, then the attribution paragraph would appear before the closing quotation mark, which would look wrong presentationally in addition to being wrong semantically.
CornedBee: I understand your reasoning in using the cite attribute for whatever source attribution fits, even when it is not a link. Indeed, it would seem to me more sensible that the cite attribute could be used that way. However, HTML 4.01 at section 9.2.2 states specifically that the value of the cite attribute is a URI—so technically, anything that is not a URI is not a valid value for cite.