I can't see that giving presents back is going to achieve anything at all - in no way is it going to improve relations, but if you want to worsen them it will work.
On the other hand if you send them back and the relationship breaks down totally, your son will think it is his fault for what he said - however much you try to tell him it isn't.
It's very hard to work out the dynamic here.
Do your Dh and the uncle (your Dh's DB?) refer to their mother as stinky old nana when they talk to your son about her 'stinky old nana is coming fro Christmas etc' or has he overheard them talking about stinky old Mum or what ?
Pushing away a child and being unforgiving to him is awful behaviour from her, but to me it suggests she was very hurt. Now most people would not be very hurt at a child calling them stinky old nana, they would laugh it off or say 'me stinky - what about you?' or something.
So why was she so hurt ? - maybe because she suddenly felt she is the but of some kind of secret family joke or that she is always referred to in a nasty way behind her back. Most people wouldn't be hurt by being called stunky old nana in agame, but they might be if they felt their sons were encouraging the grandchild to talk about her in a rude way or referring to her with casual rudeness. Maybe she has always felt herself to be the butt of family jokes.
And stupidly she backed herself into a corner and took out her hurt on the child because he's the easiest to get cross with rather than two grown men. That is very wrong of her of course, and very very sad for your son poor little chap.
I would go with what your son wants, it sounds as if he wants to repair the relationship, don;t get him to apologise, he;s done that already. She's had time to calm down a bit now - your DH should phone her and say he and his brother are to blame for the rudeness, the child had no idea it was not an acceptable joke and is very upset. he would like her to get in touch and chat and for all to be forgiven and forgotten and will she please speak to your son and mend the fences.
Then the ball is in her court - she either moves on or she doesn't.
But the chance to repair things is now - it will only get harder if you leave it. If you are happy for no contact because the whole thing is much deeper than this incident then that's fine, if you want a last go at building an attachment - keep the gifts and thank her for them.
People don't act so OTT because a child makes a silly remark - there has to be a bigger reason, it might be that MIL is an awful person, it might be that something touched a very raw nerve with her - it sounds as if everyone caught up in this is unhappy at the moment, my instinct would be to try to make it better. (With the obvious proviso that if it happened again then it is an unacceptable pattern of behaviour from her.)