I am the daughter of a child molester. He raped and molested several of my cousins, a niece, and at least one of my half sisters (that I know of). I am one of the only lucky I know of- because my mom set up crystal clear boundaries like you did. I can understand your wife having mixed feelings when it comes to dealing with your father in law, but having those boundaries is protecting your children- which is a parent's job. I am extremely grateful my mother allowed me to know my father and let me make up my own opinion of him, while still protecting me.
As a father, you're allowed to be upset with your wife, she should have told you before hand. You also need to make sure your children (male and female) know about strangers danger, bad touching, and who they can talk to about it. As a son, you need to understand it's really hard to have the person you're supposed to be able to trust most, be one to be afraid of and hurt by. It leaves a lot of very mixed and confused feelings.. and while your wife may be fine it really helped me to talk to a psychiatrist. She may not need it, but I did-so maybe you can delicately bring it up. As far as your father in law goes, don't give way. It's your children, they need to be kept safe. That doesn't mean they aren't allowed to be around them, just carefully watched. It may hurt his feelings and he may not understand, but that's an unfortunate gamble you'll have to make.
Its so hard, their are so many sickos out there.
I say ur protecting them..this is why im not leaving my daughter(when I have her) with anyone till shes able to speak and knows right from wrong.. And even after that ill be extremly cautious.