S.E.
It sounds like you are the sister with the gentle nature and your sister is strong willed and stubborn. If that is the case there is nothing you will ever be able to do. You have to make a decision to either live with the situation or decide to limit the 2 children spend together to family outing. Once the 2 are older and going to school they will have there own friends and this will probably be a thing of the past.
I had something very similar but our children were boys. Lucky we did not live in the same town. Our children are now 17 and 18 years old. They get along very well but sister is still the same way. People are who they are, you just have to decide what you feel is right. (I was not going to be the one to let my son be blamed to I limited the time they spent together till they were in school. My son went to a private Christian School and her son went to the public school. It all worked out.)
Good Luck