You know, here's what I try to remember in these situations... be true to yourself and the rest will work out. You aren't accountable for what is done to you, but in the way you respond. That doesn't mean to be a door mat for this woman and it doesn't mean to erect razor wire along the property line. Handle yourself with dignity and the rest will be fine.
Honestly, if it were me (and I admit, I can tend to get kind of spiteful in situations like these), her children would not be welcome in my yard whether she's out there or not. Just because you're neighbors doesn't mean you have to be friends, and since she has not shown you anything but disrespect and outright rudeness, there's no reason to let her children take advantage of you. Plus, by allowing your kids to play with hers, there is the near certainty that something like this will happen again and again and your kids will get their feelings hurt again. I'd stay away from her and if she asks what the problem is, simply tell her that you don't have room in your life for that kind of negative behavior.
I know it's hard to hurt a child's feeling by telling them they can't come play, but you could always tell her that her mother can explain it to her. 
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