Hi Kala,
How unfortunate to be dealing with an issue like this on your first sale!
From what I understand, the customer's interaction with you does look suspicious. If there is no way to resolve the issue with an exchange or only a partial refund and if you are afraid of negative feedback, then what if you were to try to delay the matter by engaging with the customer in further negotiations, so that the feedback option expires. The item was sold on May 24, in August 24 the option to leave feedback will expire. Not my personal prefernce, but still an option...
If you cannot delay it or if you do get unreasonable negative feedback while you are negotiating, then do know that you can always approach Etsy Support and ask them to remove feedback. To do that, however, you will have to have all of your fact supported by relevant documentation, such as convos saved that indicate your attempts at resolving the matter in a reasonable way, screenshot of the policies that shows the date they were posted and exactly what they say (hopefully, you didn't update your policies after that sale and so you can show the policies you had in place at the time of the purchase), etc. Do all of your interactions with this customer in a way that you would to prove to Etsy you are trying to be fair.
By the way, what is this customer's standing? What has her feedback been like?
Hope it will get resolved!