Your best option is to get the payer to cancel the 1099 (issue a corrected 1099 with zero in box 7). Reimbursement for an actual loss is not taxable.
Or, leave it off your tax return and e-file. When the IRS sends the automated letter noticing that you did not report it, you will reply with the details of the situation including copies of correspondence, police reports, etc.
Or, you can include the income with an adjustment. To prevent the income from being classed as self-employment, answer all the test questions as no -- not similar to your job, not intended to earn a profit, not like income from a previous year, not planning on doing the same work next year. That should get it included as "other income" without SE tax. Then, go to the section for other uncommon income and enter an item of income with a negative amount that offsets and cancels out the income from the 1099. The negative entry may prevent e-filing, and the IRS will still probably send a letter asking for an explanation.
Or, leave the income off your return. Print your return and file by mail. Attach a copy of the 1099-MISC, and attach a written explanation of why you did not include it as income (but in this case, don't also include your proofs, save those in case the IRS writes back asking for more details.) This is probably the recommended procedure, but it will delay your refund a bit, and the IRS has been known to lose attachments so you may end up getting an inquiry letter anyway.
