Hi, Suzanne. Take a deep breath. I see this woman is driving you crazy, and it sounds like it's because she has no concept of reasonable boundaries. This is a big problem, and it's made even worse by the fact that your husband, her son, has not done his part as your partner and the children's father, and stood up in a reasonable way to his mother.
It also sounds like Grandma has some emotional problems, too, but I'm not here to dianose her or anyone else.
You and your husband have GOT to sit down together and make a reasonable plan to set up reasonable boundaries, and HE, NOT YOU, SHOULD BE THE ONE TO ENFORCE THEM. If necessary, you should go to a trusted counselor TOGETHER, to help the two of you work out what boundaries you need and to cope with the backlash from Grandma that is sure to come. He has no idea how to handle this -- he has to learn, and learn fast, before this crazy woman does something stupid by being alone with your daughters.
She is clearly used to getting her way 100% with her son. You are correct that she is jealous of your relationship. A lot of mothers, especially in her generation, are quite jealous of losing their grown sons to a "younger woman," so to speak.
In my opinion -- NEVER, EVER ALLOW HER TO GO PLACES AWAY FROM YOUR HOME AWAY WITH ONE OR BOTH OF YOUR DAUGHTERS. She sounds like a prime candidate for the kind of unbalanced relative who could run off with a child "for the child's own good." Clearly, she does not approve of you, and may even have it in her head that she needs to rescue the children from you.
I do suggest having a merciful attitude toward her -- she doesn't seem to understand the consequences of her actions, not having raised her son herself, and I don't think you should cut off all contact, but you MUST set up reasonable boundaries -- call before you come, limit the amount of time you are together, she has to abide by your rules for second-hand smoke, she can't contradict you or their father in front of the children, etc. All these things are simple rules of courtesy and simple common sense child-rearing.
Do not -- DO NOT -- let her take off with the children. You don't have to justify this to her or anyone else. And your husband does NOT have to make excuses for his mother. If she cannot abide by common courtesy and common sense, then she is not a suitable caregiver for a young child. That's all the justification you need.
I'm not a psychologist or a therapist, but I have had many, many, awful encounters with people (relatives included) who could not or would not respect any personal boundaries at all. Some of these people have turned out to be mentally unbalanced -- I've been stalked, and they have done other things to really hurt me emotionally and have even threatened me physically -- and such people do not respect the boundaries of the law, either. I really, really think that people who constantly and even deliberately violate everyone's boundaries are not to be trusted at all. They are capable of just about anything.
I will say a prayer that your family can resolve these issues swiftly and for the best possible situation for your marriage and the children. Try not to worry -- just make yourself and your girls safe.
Peace,
Syl