We deposited a check on July 2nd, placed the proper non local Reg. "CC" hold on the check. The hold droped off on the proper date and of course the customer came in and withrew the funds.

Today, Sept. 21, we recieved notice the check is being returned as a fradulent item. Fed says the check was lost in transit and since the check was returned within the proper time limits we must take the loss.

Is there any possible appeal to the Fed?

Probably not. If the Fed can document that the paying bank conformed to its midnight deadline in returning the check, you're stuck. But you still have the right to charge the check back to your customer, creating an overdraft.