I bought a stolen iPhone 4 on craigslist?

I bought a phone from a guy on craigslist. It was an iphone4. When i was testing my sim there with him, everything worked! Then when i got home, an hour later i couldn't call or receive calls. It would say "we're sorry but this device has been blocked from network use" when i tried calling. I put my SIM card into my old iPhone 4.It doesn't work! My sim is blocked from use! When i called AT&T, they said the iPhone was reported STOLEN so it was blocked from usage. Are you serious? So I called the guy that I bought the phone from and he said he didn't report it stolen and that he wouldn't refund my money. I have his phone number still and his craiglist listing. He took my money and reported to AT&T to get a new phone from his insurance. Wicked.
Now are there any solutions to unblock the iPhone 4 and my sim card? Will restoring the iPhone work?
If i call the police about this will it be any use or help?
Also, would I get in trouble for having a reported stolen iPhone in my hands? I mean, I didn't steal it!

First of all you can never know if he reported stolen, maybe he stole it and the person he stole it from did it.
Second of all you should check Craiglist's policy, anyways take a print screen of the page and keep the guy's name and phone number and talk to a lawyer, you might be able to sue him.
You can also try to call his insecure company and say he was bluffing and nobody stole his phone, and then the insurance company will sue him.
I would try these and if none of these worked I'd kick his s. I hate it when people do stuff like that.

By the way, you can also try to contact again AT&T or Apple and explain the situation.
Some people will be able to unblock your phone for 40$ or something like that. You can try that too.