If I were you, I'd go to a store that rents out both 1/8 and 1/4 size violins, and ask them which one fits your daughter. See what they say. Make sure you ask to work with a person who is experienced in working with string instruments and students.
Is she using a Kaan on her shoulder? If she isn't, get one. That will help her arm and her neck.
How much does she practice? If she doesn't practice enough, her arm can hurt, and if she practices too much, her arm can hurt.
I tend to agree with your husband about the teacher just wanting to make money. I would be interested to know what her answer to your question about why she thinks the 1/4 is too big now that she owns one, since SHE is the one who said her 1/8 size was too small...
If you can find a different teacher, I think it would be wise. I would be concerned both from the standpoint of her trying to shake you down for more money, and from the fact that your daughter's arm is hurting. Perhaps she doesn't know how to teach your daughter proper technique to keep her arm from hurting.
Good luck!
Dawn