Argh, that "device is in use" error message is familiar. One of many ways iTunes can fail to restore, along with the ever-popular "an unknown error has occurred", the annoyingly-meaningless numerical error code message, and the restore-"needs to be restored message"-restore-"needs to be restored message" perpetual loop.
I can't remember a guaranteed-consistently-successful way past that, but, on the other hand, am pretty sure I have managed to get past it on many occasions.
You could try DFU mode (centre-button+menu held down till it starts to reboot and then doesn't).
Or just rebooting the PC and then trying again.
Or use something like AOEMII to completely delete the partition then recreate it and format the thing (in FAT32) before trying to restore again. Or maybe just, again with AOMEII, just try rewriting the MBR.