Thanks for your replies all. It was ok - ish. I just supervised very carefully, especially when they were indoors together, and made pointed reminders loudly at children within PIL's earshot of reminding them of the dog rules and explaining why the rules were there.
The dog was actually ok and my son enjoyed a bit of supervised play and "taking" her for walks outside.
There was another near miss though - this time, not involving my children, but with my 2 year old niece. Again, dog asleep on sofa, dog was startled, woke up suddenly with a bit snap and growl and if the little girl had been standing a few inches closer would have been bitten.
I have made it very clear that the dog must not be on the sofa when she comes to visit us and my husband is also onboard with this, particularly since we witnessed my father in law allowing the dog to dig and scratch at sister-in-law's sofa on this visit! (that makes it sound like hubby is more concerned about the sofa than his child, which isn't the case, but was just another case of totally antisocial dog ownership in our book!). The concern is whether FIL will follow the rules when we are not there. But MIL is seeing more of the problem now and I think would be understanding if we said the dog can't come to us now. Hopefully it won't come to that, but FIL is a bit of a problem and totally ridiculous when it comes to his beloved dog, who he regards most definitely as an equal and top of the pecking order.