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Xena and Gabrielle's bodies never really "entered" into Illusia, but more like their consciousness, sent there by Xena's dead son, Solan. This is why when they leave Illusia, they are fully clothed, albeit wet from the ocean water, as if they just washed up on shore after falling off the cliff.
There was always an underlying sexual tension between the two, and in the world of Illusia, Ares was trying to twist her to his side, and part of doing so was to give her a different set of clothing, combat armor of his style. So he took advantage of this and cut off Xena's dress when she least expected it, which gave him the chance to see her completely naked while also giving his soldiers a chance to see her completely naked. Although Xena managed to remain calm, she clearly felt humiliated by the experience.
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