Family turmoil from cousins touching issues
It seems pretty normal to me, too. I agree with keeping an eye on them and redirecting them to other forms of play, but as long as the adults don't lead the kids to think it's a big deal, they'll forget all about this in no time and it will blow over. I hope you and your sister will make up with no hard feelings.
It sounds really normal to me. I have four kids - 7, 5, 3 and 8 months. My 5 and 3 year old take tubs together and they are often laughing and trying to grab each others penises, etc. They are obsessed with their genitals - talking about them, looking at them. My 3 year old is also VERY aware of all the terms, due to his older brothers. Penis, vagina, even butthole (ugh, embarrassing to admit that one). When my oldest was 3 he said "tushy" and that's about it. So, yes, I think its very normal, especially when exposed to older kids, for little ones to "know more" about that stuff. But it is still sounds very innocent. Your niece is still SO young, so innocent herself.
Just want to add - my 3 year old has a 4.5 year old girl pal on the block that he plays with regularly. I've found them naked, rubbing hand soap all over each other in the bathroom, writing on each others butts with markers, etc. They're usually giggling. It's not sexual, of course, just normal play.
So, how willing would you be to "let it go" the next day after your sister called your son a molester/rapist for continuing to try to touch her daughter after her daughter said "no", just because she called the next day apologizing for "losing control" during the conversation?
What you said was outrageous. I would not trust you to be a safe person around my children either--because that kind of loss of control and disgustingly inappropriate shaming response would throw up a huge red flag for me--about you and your judgement and safety.
Your niece is not capable of being a "nympho" at her age, any more than your son is a rapist. You need to apologize about MORE than "losing control". IMO.