Eye for eye?

So I was having a debate with someone today regarding "What God would want you to do" in a certain situation. Bascially, someone was doing something to him that, while not wrong in a legal way, was just not nice and was just not good business on his part. The person that I was talking to had devised a system to get around the other person's bad behavior by behaving in a not necessarily wrong, but not quite so honest, not nice bad business kind of way himself. Now, to be honest, I tend to overreact in these situations- I have been taught to "flee all appearance of evil." I also believe in mercy and in being upright at all times, even when those around you are not. So, of course, I told him that I thought he had a very very bad idea, and that I wished that he would be completely upright in this situation, even when the other guy was being a jerk. Then I threw the "What would God want you to do" line at him, and his response was that "Islam teaches that if someone does something bad to you, you do something bad back to them."

Wow.

Me: "Then I don't want to be a Muslim."
Him: "Fine. Islam doesn't beg people to follow it. It doesn't have to."
Me: ~silence~

So after we parted, I, of course, was still rather disturbed by this justification. I mean, all my life, I have been taught that mercy is so important. I have been taught to turn the other cheek. It seems that many people interpret this mercy as a sign of weakness, but I see it as a sign of strength. Yes, I could seek revenge, I could "hit you back," but I have decided not to- not because I cannot, but out of choice. It is a decision to show mercy like Jesus did on the cross, and to let God have the final word, because His comebacks are always so much better than ours ever could be.

I was wondering what, exactly, does Islam really teach about this subject? Is it really "Yeah, have at it! Someone hits you, hit them back! That will teach them to start something!" Does Islam teach mercy, and more importantly does it reward it and promote it as better than the "eye for eye" mentality?

If it abides primarily by the "eye for eye" rule, how exactly does this work? If, for instance, I overcharge you for something (which is not legally wrong, but is not kind and not good business), does that mean that I have a right to try to scam you out of your extra profit by, perhaps, lying about a situation? Or does the "eye for eye rule" only give me the right to overcharge you back (literally "an eye" for "an eye").

All I see when I think about "eye for eye" is bigger and bigger fights. If I hit you, and then you hit me back, my first reaction would be to continue the fight. I would not be prone to stop and say, "Well, I guess we are even...I hit you, you hit me, let's all go home." The first reaction is, "Hey! You hit me harder than I hit you! I'm gonna hit you back, and it is going to be even harder than you hit me!!!"

Mercy dispells wrath. God says to do nice things to your enemies. In the Old Testament, it says to feed your enemies, and that by doing so, you will "heap coals of fire on his head." Revenge by being nice. Revenge by guilt, even? It tends to project this attitude of "Yeah, you are a jerk, but that is OK. I don't need you, and I don't need you to be nice to me. I have my God, and He has got my back. You can't do anything to me that God does not see, and He is the most just Judge of all."

Really, if it literally is "eye for eye" (if you hit me, I can only hit you back as hard as you hit me, but no more), as I think that it probably is (it doesn't say "eye for ear"), then isn't this system actually more difficult than mercy? In that moment of anger, instead of stopping to completely analyze the situation and only retribute what was done to you, isn't it easier and actually more gratifying to say, "You know what? I am better than this. I don't need to justify my personhood by being the same kind of low jerk that you are. I am a good person, and no matter what you do to me, you do not have the power to change that! I don't need to exert power over you to feel good about myself. I just want to honor God with all of my actions, and I will honor him now by showing mercy and restraint to you."

What do you think that God would want you to do?