Connie,
I'm sure you'll read this but you problem won't reply due to legal reasons. So here it goes.
A good business person knows that, "The customer is always right."
It doesn't matter if you feel that he is wrong and not abiding by "your" return or exchange policy. The fact of the matter is, he bid on an item that you were selling, he won the bid, he paid, you shipped the item, and to his dismay the item that he received was not the item he bid on. It was totally not the item he bid on. May-be it wasn't false advertising and just a mistake. Yet, it's a huge mistake, made by you and "your company". Further more, just because you claim it was a mistake doesn't change the fact that it's a breach of contract. And since you breached the contract it becomes null and viod and he doesn't have to abide by your refund and exchange policy set forth in your advertisment.
Even though you said, "We will do whatever is required to fix this error and ship new parts ETC..." At that point it's up to the buyer to agree on this new contract. He obviously doesn't want to agree to a new contract seeing as the first one left him with a bad taste in his mouth.
Your company made the mistake, not him. He obviously paid to have the item reshipped to you. When you receive it, throughly check it out. Make sure it's in the same condition that he sent it to you. If all is well, do the right thing and refund him is money. Sometimes in business we have to break our own policies to extend our future business. Do the right thing here. It may cost you a few dollars in the end but we must all pay for our mistakes.
If he decides to do so, he'll have no problem winning this case in small claims court. Is $1065.00 worth your trouble?
If I were you connie, and i made the same mistake, i would have no problem returning his money to him and moving on. Just do the right thing here.