A long thread with a mix of good advice to whcih I would add my simple thoughts.
1) Yes, you broke the golden rule and as a result this 'nice' neighbour is (potentially wilfully?) taking advantage of you. If she as you say is well connected the risk, which only you can assess, is that by changing the footing you have with her she could affect your business!
2) ref your business - you say it is a community of 1500, well I presume you have already made some inroads and sold somewhere amongst them at commercial prices that your neighbour has had no affect over???
3) You remarked that her hubby had copied your images and cropped out the watermark ~ don't they know about copyright laws in your town!
3a) You initial goodwill is being abused ~ yes it makes sense to create good connections as word of mouth is important but based on what you say so far "she" is not helping you build the business.
4) ref the party - leave the camera at home but IMO I suggest you let her know in advance that you would be delighted to join the fun and celebrate the 1st birthday. If she asks about you taking pictures well now as is a good a time as any to put the matter on a business versus pleasure footing ~ letter of agreement up front that details special rates (as needed). IMO this needs no other explanation than to gently remind her that photography is your business and that you are simply formalising the way you transact it.
4a) I know from personal experience that not all neighbours are good ones ~ if she makes life hard then that will just have to be taken on the chin because again based on your OP and the updates so far this could be a "no win" situation ~ blackmail is too strong a word for what she could do, so split the business from the pleasure and formalise it as soon as possible. Do not make excuses or white lies ~ if push comes to shove and I know not what business her hubby is in but as appropriate think of an analogy relating to it to show that business needs protecting & developing. By this I mean if he is a motor engineer you would not expect him to halve his hourly rate for you and also supply parts at cost, afterall sparkplugs are only $5 so why are they $15 on the bill (no idea of real prices just trying to show my thinking).
Best of luck with the business and what you decide to do