It sucks that you are encountering this, but do realize something: while you’ve paid once, you have the choice to no longer pay anymore for this badly designed product.
You do this by not giving Microsoft your business anymore, and using a different brand of mp3 player. Screw that $160 replacement fee, that’s pretty much an iPod right there, so go give Apple your money. This is the only way you can communicate with businesses as large and nonchalant as Microsoft, as they work for shareholders who care most about profit. If you want, you could call up customer support and tell them you are dissatisfied with their policy and thus going to buy Apple products in the future, but I doubt if this will accomplish anything beyond being therapeutic (still, that’s a good enough reason for me).
Is it fair? Legally yes (until they get sued in a big class action thing, as this usually goes), businesswise it’s sketchy but obviously Microsoft has chosen to follow the approach of releasing shoddy hardware when they know it has significant faults, versus improving and releasing a solid model later on (they’ve admitted to doing this, in causing the RROD fiasco). Now we see they’ve done the same with the Zune. I would use this knowledge and no longer support Microsoft products…. oh wait, I’ve been doing that for pretty much my entire life :)
I think them not paying for the shipping costs is bad customer service, and ultimately causes more damage to their brand than they regain in saving money. Now that I know this is the case, my opinion of the PS3 has gone up a bit, and mine of Microsoft has gone down yet again.
I personally would recommend any version of iPod as I have always been impressed with their quality. I use an iPod Touch and it is my media center, I appreciate it very much. There are other brands if you are not an Apple fan, lots of third party brands and devices which play music and movies (Samsung, Sony… just go look in your electronic shop).
On a more general note, the Microsoft that Bill Gates made and ran is no longer the Microsoft that exists today. All I see them doing nowadays is playing catchup (IE) and releasing products the market has no need for (Vista, even Windows 7). They are no longer the bringers of innovation that they once were. Indie companies as well as bigger ones are taking the innovation lead. As our computing needs change, I can easily see a future world without Microsoft, as surprising as that may be.