SELECT @str2 = SUBSTRING(@Str1,1,@offset-1) + @char + Substring(@Str1,@offset+1,len(@str1)) 

----------------------------------------------------------------------------------------------------------------------------------------------------------------------

You can check my BLOG here

declare @String varchar(1000), @String2 varchar(1000),
@Letter char(1), @Occurance int, @Replace char(1)

select @String = 'Susy sells sea shells by the sea shore.', 
@String2 = '',
@Letter = 's',
@Occurance = 3,
@Replace = 'X'

;with Chars ([Char], [Pos], Ord) as
	(select substring(@String, number, 1), 
	row_number() over (partition by substring(@String, number, 1) order by number),
	number
	from common.dbo.smallnumbers
	where number between 1 and len(@String))
select @String2 = 
	@String2 +
	case
		when [Char] = @Letter and [Pos] = @Occurance then @Replace
		else [Char]
	end
from Chars
order by ord

select @String2