The answer is: the blocks work normally, but the domains are encoded in punycode. That means that when you block domain:
dömain.com
It will appear in your blocklist (either individually as an individual user or in the blocked list if you're moderating the whole server) as:
xn--dmain-jua.com
You don't need to take any additional action, this is just what the domain looks like in punycode.
More about Punycode:
https://en.wikipedia.org/wiki/Punycode
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