XSD files are "XML Schemas" that describe the structure of a XML document.The validator checks for well formedness first, meaning that your XML file must be parsable using a DOM/SAX parser, and only then does it validate your XML against the XML Schema.
Validating against xsd
*The maximum size limit for file upload is 2 megabytes.
You want to validate an XML document against an external XML Schema Definition (XSD) document to perform validations beyond what can be performed using the Cleanse or Business Rules shapes.
I didn't realize that the was actually reading the XSD from my hard drive from the same subdir as the XML file and validating. Just an FYI, if you use nested schemas and refer other schema using relative path such as foo\abc.xsd, make sure that you use forward slash(/) instead of backward slash (\) when validating in NPP Xml Tools plugin.
If you use backward slash, it gives schema parsing error but forward slash works fine.
Validation is automatically carried out when you switch from Text View to any other view.