This is bad news all around for your customer. First the merchandise did not meet their needs and now it is lost. Clearly state who is responsible for the merchandise and show your good will by offering to help where possible.
1234, Main Street
Boston, MA 02123
<Recipient Address Goes Here>
We have received your inquiry about <description of merchandise> and find that we have no record of it. I suggest that you contact your shipper to try and trace the lost <type of merchandise>. Unfortunately, we cannot be responsible for returned merchandise that is lost in transit.
If we can be of further service, or if you get more information, please call me and I will take action from this end. I'm sorry that the <type of merchandise> did not meet your needs and that <it is/they are> now lost. We value your business and want to help any way we can.
encl: <List of enclosed items goes here>