Oh sorry you've got to deal with this, it's a tough one. I don't think it's your place to tell this woman since she's not your friend. However, you are right, military frowns very heavily on this. He can lose rank and pay if his commander finds out, possibly even court martial. I don't know how good of a friend he is to your husband but if it's good, then your husband needs to let the guy know that he has put you into an uncomfortable situation and that you guys want no part of it. Although you don't care for this woman, you do care for his kids. I also agree with talking to him about his daughter and the treatment by the step mom. To be honest I would probably mention something to the step mom the next time I witnessed it.
Although, telling her may get her out of the step daughter's life...
Good luck.