I would agree with documenting everything and contacting a lawyer for legal advice. Whether you choose to act on it or not is totally up to you, but the advice is needed.
Be aware though, that as batcrap crazy as she is, if you really push things with her, she could very likely accuse you of sexual abuse with the kids to get you out of the picture permanently and to ruin your life in general.
I had a sister-in-.law who decided to divorce my brother and she accused him of molesting her daughter, just to try to keep him away from her. And she admitted that to me herself. It wasn’t just an assumption on my part of why she accused him of it.
Keep that in mind when talking to the lawyer and ask him about the ramifications of that.
In the meantime, pray like never before. God can often provide solutions that we never would have expected.
Your daughter-in-law has some very serious issues to deal with from her past, and until and unless she addresses them, it’s unlikely things will change for you.
I will pray for a resolution to this problem.
Indeed. If she was herself abused or molested as a child, there is a better than even chance that she sees her father-in-law as a potential if not actual abuser. At first she'd confine herself to sharing this projection delusion with her husband, but one day something could trigger her to accuse him to the authorities. This must be avoided at all costs.