I dunno... I would be the first to "whip it out" right there in front of everybody, if my baby needed to eat. We are trying to make breastfeeding the norm in our society, and people need to get over their hangups about breasts. They are for feeding babies. That's it. That is the only purpose of boobs. You don't have to cover up when you nurse, if you are comfortable not covering up. It was fine for my son, but my daughter would not tolerate me covering her head.
I don't think your neighbor did anything wrong, and I don't think your son is actually traumatized. Just tell him that nursing is normal and what boobs are for, and leave it at that.
I think we need to also put ourselves in this neighbor's position: baby is nursing, child is staring and wondering what is going on. What do you do? Your son probably asked her what was going on. What should she do? What any normal mother would... just tell him that the baby is eating or drinking milk. It's NORMAL.
I might actually be thankful that she provided you with this teaching moment. Maybe if your kids could be around more often while she is taking care of the baby, they would get more used to it and not even notice anymore. They are only obsessing because they don't think it's normal. Once they realize that it is, they will stop thinking about it at all.