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Are they saying that this happened because of a fault of yours so that they are saying you made an error and they are blaming you so they want to work with someone else?
Did you offer to pay the fine?
In your first post you said the by-law officer was called and gave a fine. Did you mean to say he said it was all fine but recommended some further safety steps and you agreed to take them?
The reason why this matters is that you had a binding contract. There was an offer and an acceptance of that offer in terms of what was to be done and the cost etc.
But it seems they have lost confidence in you and would likely take the position that either you mis-represented your expertise or that you breached the contract by not providing what they were paying for.
In other words, my concern is that because you were told you were not doing the work safely by the by-law officer and because you didn't get the permit ( and I know you did ask and were given the wrong information) it may very well be that a court would say that they had ever right to consider the contract to be at an end.
So I am not confident that you would win in court if you sued them.
Do you see what I mean?
Yes. They should at least pay for any materials you bought as they are ahead by having them. I suggest you just try to come to some agreement with them. They will be happy to get back most of the deposit without having to sue I am sure.