Very disheartening to hear this.. I am so glad you suspected something was amiss before the "fraud" had the chance to play out. There is way more to this story than I think you might ever know. Do let us know what Pay Pal has to say about this , if there is more follow -up. So many of us have gotten used to this convienience believing it was the safest way to transact on-line.
My guess is that if someone hacked the pay pal account they also hacked the e- mail address. But that whole phone issue .. and now its disconnected... HMMM thats the part that really makes all of it very very suspititous.
You may want to consider calling the Police Department for that Town/City.