@AS3 I struggled with this exact same question for a while too. When I followed it all through, I think @BillM223 has given us the right answer.
What it means is that yes, you were taxed (or are about to be) taxed on that income for the year that your you made that HSA contribution via your employer.
I too thought I shouldn't be taxed on it, since I withdrew the excess contributions. The problem is, when you (and I too!) made that HSA contribution via your employer, your employer deducted that from your taxable income for those pay period(s), so each dollar you contributed reduced your taxable income by a dollar on the W-2 for the year. The fact that you withdraw the excess contribution has no effect on that. So, yes, now it is as if you never contributed that money to your HSA in the first place ... but this means now you're no longer entitled to that reduction in taxable income that's still on your W-2.
So, it has to get added back in as taxable income (I would argue that it should be added back in on the "Wages" line on 1040 Line 1, but I guess the IRS directs us to "Other income" instead so we can add that note about excess contribution and Form 8889.
On the bright side, even though you still get taxed on it, by withdrawing the excess contribution you do wind up saving yourself the penalty you would otherwise pay had you not withdrawn it. And you still get to keep that withdrawn contribution, so it all balances out.
