If this discussion with the customer service rep did occur as written, it's the most ridiculous one I've seen yet, though. It's a major customer service fail even if the original reason for freezing the account was valid.
Fraud of this sort of thing is a difficult thing to solve. I don't envy Paypal's position here. However, their approaches are unprofessional at best....
From one point of view, they're no more "unprofessional" with their customer service than Google. At least there was a phone number to call and a person to answer it - even if they were apparently not highly trained enough or authorized to solve the problem.
Paypal are trying to solve the credit card version of "web scale" - they've got their almighty "fraud detection algorithm", with the knobs inevitably turned towards "risk pissing off low value customers" rather than "risk letting through financial risk exposing transactions". When you want to let everyone with a hotmail account and a prepaid debit card become a "merchant", it's inevitable that there are going to be _lots_ of edge cases, and not nearly enough skilled customer service people.
If you can look critically at what you're doing, and it seems like it _might_ be an "edge case", you might want to think twice about using Paypal.
Given that in my case, IT services were an "edge case" I would suggest that we can just shorten that to "you might want to think twice about using Paypal."
It's like a page out of the "let me jam a pineapple up your ass" book of customer service.
More so, people can use paypal without having any amount of experience with alternate payment processing methods, so they have no yard stick of comparison. They just don't know that any payment processor in the world would stomp all over them to the same or greater degree, so they merely level a harangue at paypal for not living up perfection.
OP's situation is pretty weird. If that conversation actually occurred, it wasn't handled well at all, and PayPal may well have done a lot wrong here. That doesn't mean it wasn't a high risk situation when PayPal initially froze the account to stop it from getting riskier.
I also think the OP's wrong about losing fees on everything twice even though the payments were refunded. When you refund something through PayPal, PayPal refunds its fees to you, even if it was a credit card transaction.
Even if that was indeed the case, a simple investigation of the issue would have cleared things up. Businesses are supposed to work with customers, not fuck them over at the first sign of trouble.
I hate to come down on the side of Paypal, but it would be so easy to abuse the donation button by doing exactly this, and not sending out any gifts. There is no way paypal can test this.
(I actually spent a half hour talking to my PayPal account manager today about this very subject, presenting different charges and asking why fees were or were not kept in various situations; however, I do use micropayments, so my results are not going to be terribly relevant, and we are actually continuing the conversation tomorrow. ;P)
Also, the actual items being sold were "mystery" gifts, not actual items.
My guess is that paypal views this as high risk because someone is sending money to OP, and OP is sending "something" to someone else. It's not trackable through PayPal's system, which means there is a high potential for chargebacks, which cost PayPal (and everyone else involved) money.
This seems like an extremely reasonable freeze to me, especially given that the PayPal rep told OP exactly what OP could do to sell these items: ship to the actual buyer and tell them what they are getting, and do so under a different name than your original attempt. That's kind of the only way it can work.
Note that I'm not saying this is the case here, but this is the risk from the payment processor's standpoint.