R.,
The way I see it you can allow her to talk to/see your daughter--she's 5, right? She knows about her dad, so she would probably realize that HE has a mother.....you can always explain to your daughter that grandma live all over the country and is always moving but right now she is nearby and would like to see her.
OR...do nothing and let her go ahead and file for visitation (I doubt she can file for custody) which she most likely will not do.
Overall though, I think your daughter has a right to meet and know her grandmother--however flaky--unless she is a source of danger (addiction, etc.). It's part of her family. And her history, after all.
@R....you haven't talked to her or seen her in 2 years! People change. All I know is put yourself in her shoes--what if your daughter had a child and you never knew him or her? All she wanted was to talk to her on the phone!