How dare he insult me in front of all these people? I'll show him how things work in the real world!
Explain to him that I didn't take his toy and give him fair warning that he'll have a black eye if he doesn't drop it.
Try to rationalize with the kid. Tell him you didn't take the toy and refuse to fight him even if he takes a few swings at you.
Tell him you didn't take the toy and direct him to someone who can help him find it.
Explain to him you didn't take the toy and offer to personally help find the person who did.