Been there, done that! I have the WORST psycho MIL on the planet!
Saying something will always put you in a rock and a hard place. If your MIL was mature and knew how to handle relationships, she would've gone to you directly in the first place, instead of your husband. She would also see that it is WRONG to speak badly of her son's spouse to him. I would give up on the idea that speaking your mind to her would change anything, other than make you feel better. I would first go to your husband and somehow tackfully say that it hurts your feelings that she would say things about you that were ugly, plus trying to hurt the kids at that. It REALLY is his place to set boundaries and limits, no matter how much they hate to do that with their parents. IF he is a non-confrontational person like my husband, you could tackfully go directly to her and speak your mind, but let him know first. That way, she is not going and tattling and putting him in the middle, which sounds like she loves to do. I would NOT expect her to change. Plus, it sounds like he and she are somewhat close, if they are having lunch together.
I did the confrontation thing (via email, then phone) and the Monster In Law and I didn't speak for 11 months. She missed out on her grandchild being born, because of her inability to own up to her own mistakes, is the way I see it. The more I didn't speak to her, the more she would go to my husband and make herself out to be the morter. About how horrible I was, etc. When she NEVER acknowledged that she'd ever done anything wrong. But also, not having anything to do with her made my life so much happier! Funny! She was and is still very destructive to our relationship and our family, but now I just don't have much to do with her, instead of expecting an honest and friendly relationship. You definitely should talk to your husband about how it makes you feel when he allows someone (anyone) to say bad things about you, and how would it make HIM feel if you did the same.
Also, MIL's do strange things when they have too much time on their hands. I would still try to find her a job and a spouse, if she's not married. Keep you enemies close and occupied, I say!
Don't expect her to change - she never will.
If all else doesn't work, just be cordial and see her as rarely as possible. Also, plan your come-backs. If you know you'll be in a situation with her, plan what you'll say if she says something negative, even if it's just "What is that supposed to mean?" "Oh, you watch too many soap operas!", etc. It does help and shows her you won't lie down and take anything, while also taking the high road. I'm not for shutting up and just letting people say what they want - that to me, doesn't show others that you respect yourself. It's your family and she needs to be respectful.
Good luck and let me know how it goes.
L.