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Avoid the rush, tell her the truth.
Ask him and your mother in law and your wife and all family members ta sit down and confront him with it.
Let him know how you feel and see how the rest of the family responds. Try not to cause a schism between bloo kin but you now must take the high ground and discipline the grandfather in FRONT of your kids with family present to show that th family unit as a whole, no matter how young or old must be hed accountab for their actions. This will show the kids that rank in the collective group is established by good deeds and respect and responsibility.
That way the kids will realize that parents and grandparents make boo boos too and say bad words. Once that's done have a " Boo Boo Bad Word Party " with a cake and grandpa can only have a piece if he takes responsibility and asks forgiveness. Then when that is done have the 3 year old cut the cake and give grandpa his piece.
(Make sure it's a butter knife or you may have to sew alot of people up )
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