Does the deception bother me? No, not really. Do we engage in it? No, not really. We're surrounded, in life, with people who don't believe as we do in a vast myriad of ways. Some people play the Santa thing to the hilt. My husband and I decided not to do Santa or the Easter bunny. We're very scientifically-minded people, and we want to portray facts as facts and beliefs as beliefs, so we've approached the holiday characters the way we approach religion: we tell the children what we believe, and why, but then also tell them that other people believe different things, and they have lots of reasons for believing those things. Some people believe differently, and as long as it isn't hurting anyone, we are respectful of that. This can apply to Santa as well.
Most of my friends do the Santa thing, and we work hard to make sure our kids don't "spoil" it for their kids (only time will tell if it's working).
I think it all comes down to what YOU are comfortable with, and it sounds like you are uncomfortable with the game continuing. It doesn't matter if other people think your kids are still young enough to believe, if you don't, then you don't have to continue. I'm not sure I would call this "lying," so much as a different parenting approach. However, as is almost always true with the MIL, you are the parent, and she doesn't get to decide how to raise your kids.
So, if you decide you are truly uncomfortable, don't participate and "cover up" for your MIL. But also, don't tell your kids that Grandma has been lying to them. At some point when they are asking questions, just ask the kids what they believe, and make them reason through it. If what they say bothers you, mention to them that this is what grandma believes and that's okay. But it isn't what you believe. Then, you've at least planted the idea that things may not be cut and dry.
Good luck.