The IRS has long said that if any income has not been officially excluded from being taxable then it should be included. So the default for this money is that it is taxable - which Massachusetts has acknowledged by sending you the 1099-G.
If I was preparing this return for you I would enter these payments in as government payments just like unemployment - taxable but not subject to self-employment tax. But your treatment - agreeing that they are taxable less previously taxed contributions - has merit and could be argued. Make sure that you save all the documentation showing the after-tax contributions and the payments you received. It's unlikely that you are audited over this but since the amount on your tax return will not match the amount on the 1099-G it may flag a review.
@Ben Molony
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