Oh. My. God.

Have just read this thread almost entirely and am going HOLY SH IT!

My first thought at the very first post was "is there something going on at their house with the kids"

Just throwing my 2c in which I'm pretty sure has been said better and far more articulately that I will, but.... :P

Document EVERYTHING. You think you'll remember. Just do a little timeline and pop it away. If she is giving your kids the finger, I think she is teaching them a very important lesson herself.

DON'T GROW UP TO BE LIKE THAT!!

I think you've handled this very very well. All you can do is continue to do what you're doing.

If you haven't already, report the issue formally through child protection services (whatever it is over there) so there is a record of it, and just avoid the b!tch.

You are on the high ground here. Morally AND legally. Do keep everyone updated.

PS - if the father did look really really mad, perhaps there is some "playing doctor" going on over there, in a bad way.