As much as the ATM owning bank may have tried to be customer-friendly in adjusting for the cash dispense error, that's not the way things should happen, of course. However, you are correct to say that you should (in fact must) refund any fee that you charged your customer that resulted from the error. The dispute was, in fact, valid. The resolution was irregular and that's what threw you off.
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John S. Burnett
BankersOnline.com
Fighting for Compliance since 1976
Bankers' Threads User #8