I work on contract for my client. I spent 4000$ from my pocket for travel/lodging/meals etc. I have to claim this money from my client who reimburses it to my employer. My employer, by mistake, paid me this expense amount also has an income.
I see in my paycheck that SSN/Medi/federal/state tax has been deducted on this amount. My employer says he cannot fix this issue. Any idea how can this be fixed by my employer or can I fix it during filing my returns.

Two thoughts:

1. Your employer CAN fix this issue, through adjustments on your next pay check. Yes, it's a bit of a pain for him, and he probably would rather ignore the issue, but his saying that he "can't" do it just shows that he's being lazy. Actually, by over-reporting your wages he is causing his own expenses to go up, as he must pay the employer's portion of employment taxes on these "wages." So it is of some benefit to him to make the adjustments. I am assuming here that this mistake occurred in 2010 and not in a prior year, so there is still time for him to make the correction prior to issuing your 2010 W2 form.

2. If your employer can't/won't fix it, then you will have over-reported income for the year. Meaning you have a higher tax bill than is appropriate. One way to fix this is to deduct the $4000 as unreimbursed business expense on your tax return. Hopefully you kept copies of all your receipts so you can document the expense for the IRS if asked. The downside to this approach is that you can only take this deduction to the extent it exceeds 2% of your adjusted gross income, and it doesn't help you recover the FICA or any state/local income tax that was withheld from your reimbursement.

Thanks ebaines for answering my question. I will speak to my employer again on this.

If you do not provide proper accounting of your expenses, your employer may be paying you under non-accountable plan. It is reported as your income. Then you can claim your job/business related expenses only if you itemize your deductions. These employee business expenses are subject to 2% AGI limit.

Under Accountable Plan (substantiated expenses), employer will report this in box 12 of W2 with code "L" which indicates substantiated employee business expenses reimbursement.