Unless you agree to a refund then they would have to open a dispute.
This would require them to return the item to you using an online trackable method - at their own expense.
You should have just reported the listing for using your photo. As you have found out it, has somewhat backfired when you challenged them.
Now they say the item is faulty you will have no choice but to accept it back. It is better to do that without a dispute being opened.
Although you seem to have forgotten to register as a business seller, you clearly are one. Items have to be fit for purpose.
Refunds must always be done via the original paypal transaction.
