At about the same time as our customer - we realized their employee was embezzling from their account.

Our customer contacted the police & the employee is now in jail awaiting trial.

Do we need to file a SAR?

I say yes - Instructions of when to file a SAR says
(b) Violations > $5,000 & suspect can be identified
. . . [illegal] transactions conducted through the financial institution where [bank was victim] . .or the financial institution was used to facilitate the transactions.

I agree. If you are aware that your institution was involved in the activity.

I have had the same situation and yes, you file a SAR.

Most definitely. File, assuming the $5,000 threshold has been reached. Failing to file in similar situations was one of the big issues involved in AmSouth's $10 million civil money penalty in 2004.