No, you are not an arsehole by any means. You sound like a fine upstanding guy to me. There are so many things wrong here... .
1. He tells you your wife has offered him sex. He has one over you now so watch out, buddy. He can snap his fingers at will and have HIS way with YOUR wife. Who does he think he is?
2. She is friendly with his wife and she does this to her? Total disrespect for the woman. About the same amount of respect she has for you.
3. She cares about everyone else but not you.
4. She sees no need to apologize.
5. She is relying on you to cover up for her (again) as you usually do, as you have done all these years so who the hell do you think you are going and telling his wife about this?
If I were you, I would be telling his wife in his presence straight away. You need to get this couple out of your life. She could ofcourse run off with him but better now than later. You might point this out to her / your family so she knows she can't get away with this sh!t. They hate being found out and this might deter her from crossing your boundaries again.
Set up and enforce boundaries, set up an exit plan just for good measure and take control. Do it while you are still thinking clearly and logically. Your concern that she might withdraw from you and the kids is a genuine one and I don't even have 0.02c to chip in here. I hope you find a solution and resolve this horrible issue. Good luck.
A boundary is about protecting you at your core, it does not take into consideration the feelings of others, nor what they they think of you. It is your bottom line.
What is your bottom line, what is hurting you? My guess is that this is going on, the uncertainty, lack of trust, feeling powerless and manipulated etc...
If this is it then you need this to stop. It is not negotiable. You wont live this way, so you ensure it stops or you refuse to stay in a RS where this is going on.
Two people who have been involved like this can rarely get on platonically after this even if they dont have a disorder. A pwBPD cannot be predicted or relied upon. So you have to enact yoru boundaries so that you are not exposed to it. You cannot control what she does or doesn't do by means of demands or negotiations.
Involving his wife is just passing that responsibility for your welfare onto someones else's actions. It also causes you to be a source of passive aggression, and you can loose control of the consequences and take on more blame (projection). Concentrate on your actions that you have control over to protect you from what is eating you up. Everyone else can sort themselves out, you cannot do this for them