How to display post title and link within wp_list_categories()

Off the top of my head, you can achieve the desired effect in two different ways.

Extend the Category Walker

Extend the Walker_Category() class and overwrite the start_el() method with similar code that retrieves a list of posts in the category being processed and displays them in an unordered list within the category’s <li> element. To use your new walker class, pass it’s name in the walker argument of wp_list_categories().

Procedurally Process Cateogries

Rather than having wp_list_categories() echo out a list of categories, set the echo argument to false, set a variable to the function call’s return value, and use the PHP regular expression and string functions to modify the markup as needed.

The second solution can alternately be achieved by hooking into the wp_list_categories filter, which receives the same generated markup as an argument that wp_list_categories() returns when echo is set to false.