#1 Paypal has the USPS shipping integrated.
#2 PPcal has an area in shipping with a USPS ID: and USPS Password: Which you will need to set an accout up with the USPS seperately.

My site is simple, I will sell a product.
Customer will hopefully buy my product.
If the customer decides to return my product
I will refund the customer everything, but the shipping and handling cost.
I will have to go through this process, Which I got at the FAQ on this site.. (PayPal allows you to do a partial refund. Under the corresponding PayPal "refund" functionality you should simply adjust the amount of refund, so that it will exclude shipping / handling fees)

Which shipping method is above would be best to use?

With v3.5 of our shopping cart you can either use live shipping rates from USPS or UPS server or create custom shipping services with custom shipping tables for each of these services. For example you can create "US express shipping" and "International express shipping" and create shipping rate table for each of these 2 services. These rates can be based on the weight of the items or qty, or their cost.

In any case, shipping and handling cost should be deducted from transaction total when doing a refund via paypal. You will see shipping and handling costs under paypal transaction as separate lines.