I would reply with "Merry Christmas".  I wouldn't worry about offending the person since they greeted me that way first.  Plus, even if I didn't celebrate Christmas, I don't see what harm it causes wishing someone the best.  For instance, while I'm not Jewish, I wouldn't hesitate to wish someone a Happy Hanukkah if I knew that they were celebrating it.

It's really up to you. You can use "Merry Christmas." or you can say "Happy Holidays." Some people take "Merry Christmas" as offensive due to religious backgrounds. 

I say Merry CHRISTmas!  I like to put emphasis on the word of Christ!