hmmm ok, first its ok if your son appears to be more bonded with the grandad than with you. Please don't let any old bitter feelings get in the way of a chance for peace. Just enlist your FIL's help. Ask him to re enforce his "instructions" to your son by making comments like, "I'm sure your mom would appreciate" or "that's just how your dad wants you to ". It will keep your son looking to you for guidance in the future. At 1yr old the baby is going where he gets the most cuddles, and yes where he can manipulate.
You could try laying down with your son until he falls asleep, or having him fall asleep in your arms, and then putting him in his own bed. that way you have provided the same comfort to him. Though I think as you suspect FIL and baby are taking mutual comfort in their relationship.
It is hard to live with extended family these days because we are out of practice. Try to appreciate the good things in the arrangement. Recognize whether you are taking advantage of the benefits to you, and then wanting deny the benefits FIL is getting from the relationship. A strong bond with a grandparent who is a good influence (as opposed to being a reprobate) can add a lot to a young persons life.
I personally don't believe that cleaving to each other was meant to be at the expense of other family ties, and it seems that you guys feel you don't want to cause disharmony between your dh and his dad.
Yes, eventually your dh will have to come to terms with how much power he is going to allow his father to have/continue to have over his life. He might even find his dad gains a new respect for him if he takes a stand. But, it is not for you to demand this of him. As long as your son is safe with his grandad I really wouldn't make too much out of it.
And Yes, I have stood up to my FIL. Not about the kids, but when he stayed with us for a few weeks, and would be crabby or start sounding short tempered. I would look him right in the eye and tell him, if you need a time out just say so, and don't be comin in here gettin on my case. Crusty ol' fella that he is, he would disappear for a couple of hours and be fine when he came back. No, never an apology but then I learned early in life not to expect one from men of that generation.
Long winded I know, but good luck with it and don't let yourself get all caught up in what you think you should be doing or what you think dh should be doing. FIL will most likely move on soon anyway. And it can't be any fun for your dh to listen to complaints about his dad all the time.
I am saying don't let it come between you and your spouse.