How can one decline a proposal kindly without causing offence?

Decline promptly, briefly, politely and through the same channel the proposal came by.
Do not delay the answer too long, because it gives false hope and prevents the man from proposing to someone else. Convey it through the wali or intermediary, give thanks for the honour, and give a general reason such as "we are not yet compatible" without revealing faults or comparing with others. Return any token or gift already received. Do not spread the story of the proposal around. For the side that is declined, accept it with contentment; one's spouse is in Allah's hands and a refusal is not an insult. See khitbah.