I figured I'd try to put down what I've accumulated in other posts on zen-cart on this subject, perhaps we can throw something like this in the wiki.

HOW TO mark an order as "cancelled" without deleting it:

Admin > Localization > Order Status
Click Insert
Type in "Canceled" and click insert again
(note: for me this was the 5th order status, you can also edit "Delivered" to "Shipped" here)

HOW TO Restock:

Just manually edit the stock quantity under the admin > categories/products product page, there's not automated way to do this yet.

HOW TO Refund:

Refund through whatever means the customer paid with. (ie: issue refund through paypal)

Problems with this:

Problems with Order Status "Cancelled":

1) Need to manually restock and refund funds if collected
2) Products Purchased report under Admin > Reports > Products Purchased is going to be incorrect
3) Sales Report (from add-on) Admin > Reports > Sales Report is going to be incorrect. Figures from "sales" with order status canceled are still going to appear in sales report.
For a hack on how to fix that click here.
4) Other reports (that I don't use) are going to be off: Products Profit, Customers Orders-Total