Sorry to hear that this happened to you. I had this happen once when I've tried to move contents from an archive rather than copy them. The contents of the directory I was moving files into got wiped clean. It's caused either by a bad argument passed to the unarchiving command in the ARexx script or a bug in the unarchiving command itself.
As far as recovery goes, I was fortunate enough to have the .deldir option in PFS set up and was able to recover everything. You can probably recover enough of the missing C: files from a 3.1 Workbench disk to get the CD drive mounted. Once you do, you can restore the rest of the C: directory from the 3.5 CD and bring your system back up from there without reformatting.
Hopefully that'll help.
