Hi Lana,
This has happened to me on a few occasions. It does make you feel uneasy. Why I put in my Policies no refunds for Customs Refusal.
That is really there as a deterrent, and I will then attempt to feel out the customer with a kindly worded message.
I would contact the customer, and say you received the package back, and ask if there is a problem. Possibly, the customer will not respond. But, if they do, you should refund the purchase price including shipping. I know, "bummer"!
In order to be able to cancel a transaction, you must have attempted communication with the buyer. You must also refund in full (including shipping, and no "re-stocking fee.") to be able to cancel. Canceling a transaction will remove the item from your visible "sold items" that many customers might look at before making a purchase, for whatever reason. If that transaction isn't canceled, and you re-list the item, a customer could conceivably see the item was sold, and is now available again, wondering what is "wrong" with the item. I had this happen on a bracelet once, before I knew about canceling transactions. And though I was able to explain to the customer why the return was made (since I don't generally accept returns, unless I have made an error), it caused a lack of confidence with the buyer. Something we try to avoid like the plague.
So, in short, sorry to say, if you are going to re-list the item (after all, it is in your possession), you will need to refund, whether or not you actually hear from the customer. Give them the benefit of the doubt-- one customer had a problem getting to Customs in time, and I re-sent the package (she paid again for shipping through PayPal).
This is called, "the cost of doing business."