You can refund orders paid via PayPal as long as you fill out the PayPal API information in Account > Payments.
To obtain your Paypal API:
Log into the Admin, go to the Account Tab, and select the Payments Tab.
In a separate tab or window, log into PayPal and go to Profile. Under Profile, click on "Profile and Settings".
Click on "My Selling Tools".
Click on "Update" for the "API Access" item.
Click "Request API Credentials" on the API Access page. Note: If you've already generated an API signature, a "View API Signature" link is displayed instead.
Copy and Paste the API username, API password, and API signature from PayPal to their respective fields in your Admin.
For a more robust walkthrough please look at PayPal's API Credentials page, and scroll down to the "Creating an API signature" section