sed delete and replace on top of file is not working as expected

Either Perl or awk are better tools for this task. For example, use this Perl one-liner:

perl -i.bak -ne 'print "line1 data\nline2 data\nline3 data\n" if $. == 1; next if 1..3; print;' file.txt

The Perl one-liner uses these command line flags:
-e : Tells Perl to look for code in-line, instead of in a file.
-n : Loop over the input one line at a time, assigning it to $_ by default.
-i.bak : Edit input files in-place (overwrite the input file). Before overwriting, save a backup copy of the original file by appending to its name the extension .bak. If you want to skip writing a backup file, just use -i and skip the extension.

$. : Current input line number.
next if 1..3; print; : skip a line if line number is between 1 and 3, inclusive. Otherwise, print the line.

See also:

• perldoc perlrun: how to execute the Perl interpreter: command line switches
• perldoc perlvar: Perl predefined variables

This might work for you (GNU sed):

sed -i.bak '1,3c\line1\nline2\nline3' file

Change lines 1 to 3 and make a backup of the original file in file.bak.

Alternatively use:

sed -i.bak '1,3c\
line1\
line2\
line3' file

Where you place a \ at the end of each line after the c command to represent a newline.

You might exploit GNU sed for this task following way, let file.txt content be

Able
Baker
Charlie
Dog
Easy

then

sed '1,3d;4i uno\ndos\ntres' file.txt

gives output

uno
dos
tres
Dog
Easy

Explanation: I instruct GNU sed that for lines 1,3 (inclusive,inclusive) it should delete than and for 4th line it should insert provided text before that line. Observe that there is not trailing newline character, as it will be added by GNU sed. If you want to know more about i command then read sed commands summary.

(tested in GNU sed 4.9)