Well, I guess the only good thing to come out of this misadventure is that your friend is unlikely to buy to you clothing as a gift in the future.
Gifts, especially ones where the person giving the item has gone to considerable effort, are hard to reject without making the person feel personally rejected. But, on the other hand, what do you do with the inappropriate item? My advice would be similar to Jules: thank the giver, suck it up, maybe wear the horrible thing a few times when the person is around, and then let it languish in your closet; if queried, just tell the person it is being dry-cleaned, or saved for a special occasion, or, as a last resort, just murmur something like "oh, yes, I must remember to wear it next time I _____". Once the holidays are over, you can always have a more sane discussion about future gift-giving and maybe set some limits, like "Your handknit sweaters are so interesting, but I have so much trouble choosing between all the ones you've already given me; I'd actually love it if this Christmas we could just exchange CDs, if that's all right with you."
Right now, though, I think you need to make up with your friend if you want the friendship to get back on track. Grab a bottle of wine, or some home-made cookies, or whatever works for the two of you, and head over to see your friend. Apologize for your "insensitivity" but DON"T explain why the gift just wasn't right (the person probably doesn't need to hear it and your aim is not to start an argument), then move on to happier topics, like something you are looking forward to doing in the future. If your friend wants to talk about the gift (or, worst, your ingratitude, bad attitude, or whatever), let him or her talk, but just listen, nodding your head from time to time. Do not try to explain or defend your choices, just let your friend vent and then try to change the topic. Friends are more important than a piece of bad clothing.