I'm another in the 'first to have a baby gets to use it' camp in these circumstances.
I get that she has a favourite name and would like to use it and has had a long time to think about a name. But you also have a long term sentimental attachment to the name and would like to use it for reasons that are no less valid.
What would have happened if the conversation was the other way around and MIL had been listing off names that your SIL liked and you'd said 'well as long as she doesn't choose xxx as that's our favourite name' - I don't think MIL would have thought that it would have been a reasonable thing for you to do. Sounds like she is trying to fight for what her dd wants (which is a reasonable thing for a mum to do for her dd, but doesn't mean that you need to give in to it!).
You're not choosing the name to spite your SIL, you're choosing it to honour your godmother. If your SIL loves the name that much then she can choose to use it too if and when she has a dd. So long as you realise that that is her prerogative just as much as it is yours to choose the name. And the family will soon figure out two different nicknames to differentiate between the two of them!
Do you know the reason why your sil likes the name - does she have a reason to use it like you do or is it just that she likes the name? I think that if I were talking names with SIL I would be tempted to say that you're not going to discuss names with her - that you have already chosen your list and you know what you want, that you don't want to know her list because you want to choose the name that is right for the baby and that you love, not something that you always feel is a second or third or fourth... choice name because the ones you did like were on somebody else's 'maybe' list.
I must admit I think you've ended up in a horrible situation - if you had already chosen the names then putting them in a list of 'potentials' means that MIL will assume that you can cross them off your list with no problem, whereas actually as you say, you have chosen them and you don't want to do that. I know there was no reason to know in advance that MIL would put a spanner in the works like this - I bet you are kicking yourselves now if you are anything like me and feel you are in a bit of a lose-lose situation (having said that my mum told my bil that that they couldn't use the name that they had chosen as it was a dog's name - it's not, it's a normal little girl name and told me that my name choice was not a real name - it is, it's a really common old testament name that everybody has heard of although it's only recently become more common as a used name, she had been telling people that I was going to use a completely different name - which was the name of my teddy when I was little
and I don't think wanted to have to admit that we had called ds1 something different from what she had been telling people).
Sorry, I haven't got any really helpful ideas on how to solve the situation, but I hope that you manage to sort it out and end up with a (the?) name that you love for your child.