IMO PayPal missed the boat on this one since the item was tracked to the recipient. You might seriously look into action against them. Good luck.
This is exactly what you should do. Sue Paypal in small claims court.
When Paypal set up this dispute thing, they essentially established themselves as a private court system with their low-wage employees as unappealable judge, jury, and jailer.
In fact, given Paypal's size, you're probably not the only person with such an obvious case. A class-action suit might even be possible.
My guess is that somewhere in the fine print of the Paypal user agreement that you click a box saying you'd read and agreed to is some clause that says that you agree to be bound by the paypal dispute process yada yada yada. But, it is well-established in the US that you can not sign away, much less click away, your right to sue someone in a court of law. The authority of the legal court system can not be taken away by a private contract nor can a private contract restrict the courts.