There's a common phrase: "Vote with your feet." She's entrenched and defensive, to the point that she is vindictively killing PCs to punish players. That is never acceptable, and a very strong sign that this is beyond fixing without breaking it a bit more and starting over. You can talk to her outside the game, and that might help and is always worth trying first, but you've tried and at this point more words are unlikely to get through.
Your instinct to leave to avoid more strife, and continued unhappiness in a pastime that is supposed to be fulfilling, is right. You always have to be willing and ready to walk, else you're a willingly-captive audience. Words are hollow if you're going to stay no matter what she does. If you're going to stay, she doesn't need to change, right?
Leaving doesn't need to be hard for you or unpleasant for her
Be ready to walk, but don't try to use the idea of leaving to convince her to change, since threats aren't going to bring a defensive person out of their emotional bomb shelter. If there is no change, and it sounds like there won't be, walk.
When you leave the game, communicate clearly and without venom that this game isn't for you and that you won't be participating anymore. You don't need to justify or explain (which will just invite argument), just inform that you're not going to play. If she tries to argue with you, don't try to convince her (her permission isn't needed!), just respond by gently repeating that the game isn't for you and you won't be playing anymore, then remove yourself physically from the conversation.
You can use this calm repetition again later if she seeks you out to try to start an argument. Feel free to talk with her otherwise; she's your friend, after all. If she wants to talk about the game and you feel like it's an honest attempt to communicate, feel free to. If it becomes an argument, of it becomes an attempt to convince you to stay/return without actually changing anything, the best you can do is express your preference to not talk about that:
I prefer not to discuss returning to the game right now. How about we talk about something else?
You can repeat that as necessary when the conversation is going in unproductive directions. Also feel free to back it up with "You're my friend, but I don't want to have this conversation now" calm repetition+leaving response.
Leaving is the best thing that could happen to her as GM
She does need your help, and leaving is probably the biggest help you can give her. She can't continue like this if she ever wants to GM again. She needs to stop if she doesn't want to ruin friendships. You're doing her a favour by leaving, because leaving works.
Why does walking work? Actions speak louder than words and don't invite argument. She can't fight a person who isn't there and make them "stop being absent!" by flexing her GM muscles. You can't fight an absence, and absences don't provoke the fight/flight reflex that arguments do, but absence is very loud. And if she's not fighting, she has a chance of hearing the message sitting in that empty chair.
Walking also discharges any responsibility you might feel for the other players: you've broken the illusion that the gathering is socially OK, and shown them a way out. You've also shown the GM that the remaining players have a way out, and maybe they can now get through to her with words. But regardless, they're their own people and responsible for their own happiness and choices, so leaving also discharges your perceived responsibility: by trusting them to use their own words/actions to take care of their own needs.
Player Revolt/Intervention
You must, in an out-of-character context, talk about this with your GM. There is no rule in the world that will solve player favoritism. This conversation needs to include, bluntly
- That this behavior is making the game unfun for you
- That this behavior is making the game unfun for your table-mates
- That the behavior must end
Feelings will be hurt, if it has already gone this far.
After-Action
- Do not let either party of the couple be the GM. If they are both at the table, they must be players.
- Or, Remove one of them from the group
- Or, Remove both of them from the group
It is already too late if it has come to asking strangers on the internet.
Addendum
If you catch this earlier, the answer is much different. If you catch this early, you still have the out of character conversation, and you still do not sugar coat anything, but there is no ultimatum. You come up with a mutually agreeable solution. sometimes that is strict adherence to the rules (which may require a change in system), and sometimes that means asking her not to bring her husband. Feelings need not be bruised then. In your case, sadly, there will be hurt feelings. The cardinal rule of the hobby "these are your friends, don't be a jerk", has already been broken.
Best Answer
"Is that in character or out of character?"
Whilst it's good to try to catch these issues before they come up in a session 0, some things are not apparent until the game is running. It is impossible to prepare for and anticipate everything, and this situation to me seems like exactly the sort of thing that a session 0 could miss, and needs to be handled on-the-fly when it comes up in play.
Whenever I'm not sure of conflict between players is between the players, or between their characters (and the players are fine with it), I'll ask them. In your case, I would recommend:
This can go one of two ways. Either the player says: "Oh, this is just my character, I'm cool with it, but X wouldn't be!" in which case no problem, carry on, roll strength checks, etc.
Or the player says: "I don't want my character to just be picked up all the time just because I'm small". Now you know this is the player objecting. You might not need to say anything else. The other player (your wife in this case) would likely react with apologies, the "bad thing" never happens (i.e. is retconned), and now everyone is a little clearer on what is and is not ok.
It might be worth having a conversation afterwards to make sure everything is fine, it depends on whether you feel it is necessary depending on how well things seemed to recover in the session.
But what do I do now?
In your situation, the thing to do next, whether you want to invite this player back into the game or not, is to talk to this offended player. Admit that you didn't realise they were offended, not just roleplaying their character being offended.
If you want to invite this player back into the game, offer to discuss ways with the group (including P1) to signal when things bother you out of character, since it's all too easy to assume everything is in character. At my physical table, we use the "time out" hand gesture, but this doesn't work online when you only have your voice, so it might be as simple as just stating "out of character"; or stating "in character" before every in character dialogue. If these terms are agreeable, maybe P1 can rejoin the game and things can continue. If not, then maybe it wasn't such a good fit after all...