1. Unless your contract says you have to: don't give back the money. If your publisher chooses not to publish that's their right, but if you did what you were supposed to do and delivered an acceptable manuscript (you did read those prior posts, right?) then you're very likely entitled to keep your advance. You may be afraid of being blacklisted, but you're just as likely to be thought of as a sucker if you give back money you could have kept.
2. Unless the project was a work-for-hire: don't sit on the manuscript. Finding a new buyer does two things for you:
- It shows that the project was economically viable, and so any allegations your (now-previous) publisher may make about how your book wouldn't have sold will be undercut.
- It crystallizes and mitigates your damages which are both important. Crystallizing them means you've set the exact dollar amount: the difference between what you should have been paid and what you were paid. Mitigating them means you're trying to salvage the situation: this makes you much more sympathetic to a jury and also gives you certain technical legal advantages that I won't bore you with here.
3. Unless you want a fight: don't pick one. Just tell them that you believe you're entitled to keep it because you did what you were supposed to do under the contract. They may not bother to fight this any longer, they may get their lawyers to write you a nasty letter. If they're really trying to rattle your cage they may even hire a law firm to do it; if that happens they're taking things a bit more seriously (because they're spending money) but even that doesn't necessarily mean much. Find a lawyer of your own, brief them on the situation if you feel like it, but just stay calm. This may well blow over.
Here's the thing to try: rather than shopping for a new publishing house under #2, maybe go directly to self-publishing through the Kindle, Nook, etc. All the cases on this issue come from back in the day when these options didn't exist. There may be a benefit to not having a bunch of rejection notices from publishers if things get ugly. If I were in this situation myself, I'd probably try this.