Sibling Rivalry ( into Adulthood)

It sounds like you are the sister with the gentle nature and your sister is strong willed and stubborn. If that is the case there is nothing you will ever be able to do. You have to make a decision to either live with the situation or decide to limit the 2 children spend together to family outing. Once the 2 are older and going to school they will have there own friends and this will probably be a thing of the past.

I had something very similar but our children were boys. Lucky we did not live in the same town. Our children are now 17 and 18 years old. They get along very well but sister is still the same way. People are who they are, you just have to decide what you feel is right. (I was not going to be the one to let my son be blamed to I limited the time they spent together till they were in school. My son went to a private Christian School and her son went to the public school. It all worked out.)

Good Luck

This reminds me of my sister, my daughter & my niece. I was concerned about it when they were about this age but they eventually worked it out.
Knowing my sister would not hear me I addressed the issue with my daughter & helped her learn how & when to stand up for herself. Know that it will take years & many experiences with other girls for your daughter to figure it out~with your support. You describe your daughter as shy so I wonder if you were too. It seems that any unresolved stuff from my own childhood brought up a strong emotional charge when I saw similarities in my daughter.
In therapy I came to terms with the fact that my sister resented me for her own reasons. I grieved the loss of the fantasy relationship I wanted with her & I let go of trying to get her to approve of or appreciate me.
I get my sisterly love through wonderful friends & I wish this for you & your daughter, too.

This is a sad situation. My sister and I are also 2 yrs apart and are the best of friends (as a adults, but not as kids!). You need to talk to her about your feelings. Good luck.