Before dh and I even started thinking of names for ds1 we agreed some ground rules - we didn't want the name to start with either of our initials and we didn't want to use the name of any close friends or relatives.
We did end up using my late dad's name as a second name, but we did both come to the conclusion separately that it worked really well as a second name with the name we'd chosen as first name and dh was the first one to moot using it as I felt given what we'd decided that it was a bit cheeky to suggest it. However, when we were discussing it, one of the conditions I put on it was that just because we were using my dad's name as second name, we didn't automatically have to use dh's dad's name as second name should we have another boy - not least because I didn't like the name (Michael, sorry!) and I don't really like the way he treats dh (I met him for the third time at our wedding - dh and I had been going out for 13 years so you can see - really not close).
Could you sit down with dh and explain that when you entered into the deal, it had never occurred to you that he would be choosing the name of a close friend or relative and that this is really freaking you out (assuming your dd name isn't also from a friend or relative!) as you are such a strong believer in every child having their own name, not somebody else's name, that the thought of calling a ds after your fil is really making you feel ill/upset/etc as you're no longer picturing your fresh little baby that's half of both of you and got his whole life ahead of him but you just see a mini FIL and that he'll always be compared to his grandad, he won't ever have a chance to be his own person, and so on - get as emotional as you can (pregnancy hormones have to be useful for something occasionally given the grief they give too!) and lay the message on really thick so he understands what you are feeling about his name choice.
You might have to compromise on it being used as a middle name - certainly offer it up for that - but beg dh to chose a 'proper' name for his child and not just to burden him with one that already has made its mark in his family, so that he'll never have a chance to have his 'own' name. Also stress about nicknames - that if he does go ahead with it then in no uncertain terms will you ever call your baby 'little Michael' or 'little Mick (or whatever his dad is known as)' - that he has to have at least a nickname of his own - push whichever ones you like and if you think dh won't like them then even better as it might dissuade him from choosing Michael.
If he has been slating all your choices but not been prepared to even offer up suggestions then he has to expect to hear your honest views on the name - it's not reasonable to expect you to accept something passively even with your agreement, especially when he hasn't had the guts or decency to come up with any of his own suggestions (and even this doesn't sound like he has actually come up with his own suggestion!).
Is he named after someone in his family? If he is and there is a family tradition of honouring someone using their name then it is probably a perfectly obvious choice to him and he has probably been implicitly conditioned for this all his life. However it's a tradition that, to those that don't have it, can feel distinctly odd and horrible (and have you noticed that it can't be that much of a tradition as, royal family aside, you very rarely hear of somebody called Martin/Robert/etc the 8th for example - you get Junior and maybe the third - but not much beyond that). And if not - then how come he was allowed to have his own name and shape his own destiny but he isn't prepared to do that for his own child?
It's got to be worth talking to him about quite how strongly you feel about the disliking the name he's chosen - or rather, more the fact that it is FIL's name that he has chosen, and that you feel he has been pretty unfair in choosing a name that you'd always assumed that might get used as a middle name if it worked but would never be a first name as it belongs to somebody else in the family and that he had never given you any inkling that he was thinking along those lines.
Just out of interest, what do you think he would have said if you had chosen your mum's name as the girl's first name? Do you think he would have just said OK, or would have said that he wants the next dd to have his mum's name or rejected it out of hand because he didn't want to be reminded of his MIL all the time (or whatever). And if he names this child after his dad, do you think he will feel that the first girl that comes along will need to be named after his mum so she doesn't feel slighted by the fact that FIL has a child named after him whilst she doesn't?
Good luck!