Paypal is not a bank, they do not need to follow banking regulations. Their terms are clearly outlines in their user agreements upon signup.
Having said this, I try to use Paypal as little as possible, but they are generally cheaper than a direct merchant account. Not to mention, they are super-convenient.
paypal in uk is part of the FSA, which must follow the regulations set out by the FSA.
I have called a few friends and we will see if they will be able to recover the funds.