I wouldn't worry about number 2... she'll be out of business before long.
As far as the friend goes, I'm sorry that you've had to deal with that. I would cut contact for now and take some time to regroup. She knows you run an amazing bakery, why would she be so underhanded to you? Also, does she have any experience? I'm always quite surprised when I have a friend who bakes a dozen cupcakes that look halfway decent declare that they want to a open a bakery... seriously?
I live in a small town, also. SATURATED with cakes. We have a Spartan store, Kroger, Walmart and another superstore that has a bakery. Then we have 2 donut shops (one that sells cupcakes), a bake shop that has quit making cakes recently except for special circumstances and and a gourmet cupcake place... then like me, a lot of cottage foods home bakeries. A LOT. I think there are 2 within blocks of me. I do truffles, candies (mostly a few varieties of caramels, etc) and when I open a shop I plan on doing my candies, cannoli, cream puffs... in addition to cakes and cupcakes to set me apart.
I maintain my quality and customer service. I keep wowing everyone with my recipes... I get a lot of "Wow, you're better than VG's" (which is our spartan store and actually does make AMAZING cakes. We opened at the Farmer's Market 2 years ago and have just slowly but steadily grew our customer base. Now I'm so busy with cakes, I have to send my spouse to run the market booth. I am also flirting with hiring a baker. I have also involved myself in the local bridal association. I attend every bridal show. I attend every chamber of commerce meetings and their home/business expo. All the craft shows. Etc. I take my cards with me everywhere... In the beginning I put myself out there... low prices, fancy decor for nothing. Now, I actually have enough business that respects what I do and what I make that I don't have to do that anymore. I'm really young, but I've gotten to know the mayor, the people who run the downtown area, the people who run the farmer's market, all the local bakery owners and important city officials. I attend all city events and offer my "cakes as dessert" for no charge. I recently served cake at a block party to over a few hundred people. I made a ton of 6 inch cakes in all different flavors and served it to everyone. People kept coming back to try all the flavors. I have donated cakes and goodies for good causes... relay for life, charity events, churches, etc. Now that I've won the Marvelous Molds contest (which landed me in the local paper) I plan to keep doing contests and keep getting my cakes in magazines. Whatever I can to get my name out there and in my local paper. You all should as well. :)
They'll see what you do. It will make the difference and you'll come out on top. Slow and steady. Keep your head in your own game, and don't worry about what they do because they probably won't be doing it very long. Good luck!