Some people believe a re-gift is a way of saying, "You're not worthwhile enough for me to spend money on, so here's a leftover." Maybe your SIL is afraid you're really thinking that. You aren't, of course, but maybe she is worried.
I wouldn't pursue it. Maybe you know a sweet young thing who wears a tiny size and would look good in that dress. (Then, later, if SIL asks, you can say, "I tried it on and it just didn't look good on me - but my neighbor's niece, Jenny, asked to try it on and she looked SO hot in it that her dad is going to need to buy a shotgun. She really appreciates your taste!") If you can't find such a person, a charity thrift store would benefit by having the dress.
I have a cupboard in the back corner of the laundry room where gifts are stored, and a particular re-gifting item may come out for next Christmas, or for a birthday, if I can find a good "person match" for it. If I get a gift card to a store I don't patronize, I consider it much better to pass it on to someone who will use it than to throw it away or let it sit in a drawer for five years.
I thank the giver just as I would if it had been an ideal gift. That person wasn't obligated to give me anything at all, really - and I do appreciate the thought even if I don't happen to have appreciated the item.
However, most - not all - of my friends and relatives don't mind this sort of thing. One of my best friends and I give each other second-hand and re-gifted things on principle. We're both bargain-hunters, and we have decided that the good bargain obtained by the *giver* is a part of the gift. (Do NOT try this on people who would not understand!!) This Christmas I gave her a necklace which was too short for me but was perfect for her, and she gave me a lovely book which she enjoyed very much and which I know I will, too.