How to deal with a verbally abusive neighbour....?

I have a neighbour in her 70's....she convinced herself last year at some point that I had an affair with her husband. We are a close knit neighbourhood...everyone knows everyone.....she takes every opportunity to call me names (bit%h etc).

I've ignored her because she is not 100% mentally...but now it's getting out of hand and she's acting this way in front of my children who are 5 and 10 and disturbed about the whole thing.

I don't know if she's doing it for attention....I'm at a loss....

Even though I know she's not mentaly stable....It still hurts everytime she acts this way.

Does anyone have any ideas....tonight we are all planning to get together to do fire works and I'm afraid she's going to make yet another scene....I'm tired of being the bigger person and walking away....I think she continues to act like that b/c she knows she can...and no one ever says anything to her out of respect for her husband who is a friendly italian guy that knows and helps all the neighbours (cuts their grass or supervises the kids at the bus stop....a real nice man that everyone loves and respects).

Any thoughts or ideas would be greatly appreciated!!