Instead of being allocated to invoices, a refund can only be applied to an existing payment via the "Apply Refund" flow, which offsets the refund's outstanding balance against the payment's outstanding balance.
Go to Account → Payments screen (not the Payment Allocation form).
Right-click the payment with outstanding balance
Select "Apply Refund" from the context menu.
Select the refund from the Available Refunds dialog.
This should reduce both the payment's outstanding and the refund's outstanding balance.
You cannot apply a refund to a payment that is itself a refund or a contra.
Only refunds with an outstanding balance appear in the available refunds dialog.