I would release the funds and start over. As others have stated, you can not sell your home until this is settled and I think the chances of winning are slim. There is no guarantee that the buyer would qualify for the loan when you started, which is why there was probably a finance contingency and if this was not removed, it should state that the buyer is entitled to a full refund if they don't qualify.
A default should also be defined in the contract. If the buyer used the bank that gave you a pre-approval and made an honest effort to secure a loan, then they probably have not defaulted.
It happens from time to time, and a little more now than it did 5 years ago.... more