it's amazing, isn't it, how their words can get our heads spinning. their words are misaligned with their actions, and it's clear but still we second guess, and are confused. she is most certainly lying to you about many things - counselors worth anything would never say what she claims.
i am sorry for this situation.
you are in the great position of your grandchildren not protecting her. this is almost unbelieveable, just cuz it's not the norm. be thankful they are smart and honest.
can you try this angle?
when my then-addict sister's child was in my care, i went through the county foster care program. there is a special one for "relative foster care" so i didn't have to jump through many hoops, it was just licensed for this one child, and i got financial compensation which of course was helpful. my sister then had no say in any of the parenting of her daughter. i had total control.
i agree to work closely with the worker assigned to this case. probably a face to face meeting with him/her is a good idea at this point.