this is a good case, one you should probarbly get some kind of legal aid on,
since both businesses exsisted at the same, granted one was in an other name, it could become tricky,
that said, you guys were trading as "smithgitaurs" at that time so that helps you a lot,
is there any evidence to support the claim that the other company was called smith and jones at the time you were trading? have you checked web org ?
this could be a simple case of reverse hijacking, it seems that way, but your going to need evidence showing you were trading before them as smithgitars and they changed there name,
dont make any offers to sell the domain to them and dont reply to any letters hinting that you might sell it.
i seriously suggest you try the services of a lawyer i understand its expensive, but its the best accurate advise your going to get - see Jberryhill here -
personally, tell your friend not to speak to them over the phone again, do everything by fax / email - since they agreed over the phone to let him keep the domain, there is no proof this call happened, when its in black and white, its hard to dispute.
good luck and keep us in the loop, let us know how ya get on