Assembly 'system.web, version=4.0.0.0, culture=neutral, publickeytoken=b03f5f7f11d50a3a.' was not found in the SQL catalog
You can either use Uri.UnescapeDataString (in System), in which case you will also need to do a Replace('+', ' ') on the string before passing it to Uri.UnescapeDataString, or if you would rather not bother with it, this function is available in the Free version of SQL# (which I am the author of).

Importing System.Web is probably more work than it's worth. And in fact, it can be risky.  There is a good reason that System.Web is not in the "Supported Libraries" list that you linked to in the question: it is not guaranteed to work! You might run into situations, especially when dealing with non-US ASCII character sets, that do not behave as expected, and Microsoft will not fix it. So, unless you absolutely have to, you should be careful about adding non-supported DLLs. The DLLs in the "Supported" list have been fully tested and verified to work with SQL Server collations and any other environmental issues that are different between standard CLR running in Windows and the CLR running inside of SQL Server.

Here are some additional resources from Microsoft regarding several pitfalls to incorporating unsupported .NET Framework libraries:


Support policy for untested .NET Framework assemblies in the SQL Server CLR-hosted environment
Error message when you execute a CLR routine or use an assembly in SQL Server: "Assembly in host store has a different signature than assembly in GAC. (Exception from HRESULT: 0x80131050)"




A few notes about your code:


Please do not use .NET types for parameters, input or output. Hence, change string encodedXML to be SqlString encodedXML.
This function is deterministic so should be marked as such, else you will suffer a performance hit. Add IsDeterministic = true to the SqlFunction attribute.