Boy can I empathize! We have a very difficult situation with my in-laws in general and have run into this very problem in various incarnations ourselves. I see your question as truly being three-fold in terms of the issues you need to deal with here: How do we keep the peace? How do we go about confronting them without needing to cut all ties and how do we help our son sort it all out?
"How do we keep the peace, or do we give up and cut ties with these family members?
Ways to delay or avoid as much confrontation as possible: The other answers here all really seem to focus on answering this one. There are some great ideas and considerations here. However, the idea that any of the listed solutions will help you avoidconfrontation altogether are probably simplistic. Since I believe that at some point the extended family members are likely to see through it, I have given some ideas about how to manage the confrontation when it does occur. Really, having the family see through these methods might be a good opening for a "soft" confrontation that will help improve things for everyone. With the holidays fast approaching - the issue might come up faster than you think.
While I don't suggest cutting ties I don't think it is a good idea to just hide from confrontation when it is needed either. Avoiding confrontation at all costs, sets an example for your son that doesn't demonstrate how to stand up for yourself in a positive way. Plus, getting kicked out of preschool is a pretty big deal - I'd imagine some of these behaviors can be a bit physical at times - your kid needs to know you've got his back.
Having said that, I do suggest avoiding confrontation to a point. You don't want to host some sort of intervention meeting either. Any confrontation that arises, is likely to be best received if it arises naturally out of an unplanned situation. I recommend strongly, sitting down with your wife and really making sure the two of you are on the same page about where you want to draw the line about what can be let go of and what will result in direct, but careful confrontation. This way you avoid uneccessary confrontations, but are also not in danger of sending mixed messages either.
If confrontation is required or inevitable, how can we go about it as gracefully and lovingly as possible and avoid cutting ties altogether?
Be Sensitive. This probably goes without saying, but just in case: You are family, so, if this young man is simply going through a passing phase (which, believe or not, does happen) no worries. If not, and confrontation is required, it is important to be loving and as non-judgemental as possible. These parents, while overly - doting and indulging, are probably doing the best they can. There is a long list of reasons parents over-indulge from making up for the fact they are always at work, to laziness and just bribing/consoling to keep the peace, to trying to make a kid feel okay despite difficult differences (handicaps, emotional disabilities, etc. . . ) Things are bad enough he was kicked out of a preschool - his parents are aware there is a problem, they are probably lost, overwhelmed and possibly in semi-denial as a coping mechanism. You were asked how you keep him in line at one point. That is a good sign this isn't going on because they are clueless. Deep down they think things need to be different too. That is a good sign that things can get better with enough time and sensitivity.
There are ways to confront in the moment that are just about expressing limits and expectations. I'll just offer an example of this one. On neutral ground - or even at their house, a calm and collected, "Excuse me, (name) I am disturbed by the fact that you just hit your cousin. If my son did that to you the consequence would be _, (parent's name) what are the consequences of such behavior at your house?" Is a perfectly reasonable response that confronts the parents by communicating you expect a response that includes discipline, but respectfully leaves the specifics up to the parents (while also offering up an idea if they want to take it). On the other hand, at your own house, "Excuse me nephew, when _ happens at my house, the consequence is _ ." When the parent argues with you or swoops in to rescue their son, a response something like, "Well, when _ happens at my house, the consequence is _. My house, my rules. If you won't help me uphold these basic standards in my home, I'm going to have to ask you to leave for now and we can speak about it again another time." Then, if they do leave rather than exerting some form of discipline, make sure you tell the nephew you love him very much and hope he'll follow the rules next time he comes - having play time cut short like that will be a negative consequence for him and frees you up to do what you need to do to help sort things out with your own son.
Try not to get emotional about it. This is your kid, a kid you care about deeply, family and parenting - all things that easily get emotional. However, the less emotion you show or put into it, the more likely it is to be recieved. Demonstrate empathy, talk about how you care deeply about the well being of both boys, but try really hard to remain somewhat emotionally detached from the issue itself when discussing it - trust me, it just works better (experience speaking here!!)
Use I language: I suggest if you choose not to go to their home, or only meet on
neutral territory from here on forward, be honest when you are asked why. Just use "I" language when you are. For example, "It has been very hard for us to be at your place because our rules are so different and our son finds it confusing, while we find it worrisome that x is allowed to happen without consequence." (or whatever works for you but that makes it your problem and not neccessarily theirs) They can read between the lines, but you aren't being accusatory. You are only doing what you need to do to do what is right for your family and requiring nothing of them beyond asking them to respect the boundaries you feel necessary for your family to function.
"How do we help our son sort all of this out too?"
This part is, perhaps the most important part in the end. Life isn't fair and your child might just have to learn that a little earlier than most kids. That's okay and in some ways might even give your son a leg up when it comes to conflict resolution and coping skills as he gets older - it certainly has for our daughter.
When discussing discrepencies that will arise with your son, try to speak about why you make the discipline decisions you make positively. Do away with as much judgement of the others as you possibly can. You can get the idea across without being directly disparaging - For example, when my daughter was asking about her cousin's treatment of toys and why stuff they break gets replaced while stuff she breaks doesn't,(they break things - a LOT, and often it is not an accident) my answer was, "I want you to know how to care for the things you have so you don't live in a way that means you have to buy things lots of times and waste your money that way in the future. If you break something because you weren't being careful or because you broke it on purpose you don't get a replacement so that you will learn that not all things can easily be fixed or replaced." Notice, the answer is about what her Dad and I want for her, and not at all about her cousins or their parents. Now, she is a smart kid and realizes the implication is that her cousin's parents aren't teaching them the lesson she is getting. Her response was, why don't aunt _ and uncle _ want my cousins to know that?" My answer, It just isn't one of their priorities apparently honey. I don't know, I only know what I am trying to teach you.
It is also important to teach your son how to speak up for himself. We taught our daughter the same kind of "I Language" I mentioned earlier. For example, we taught our daughter that she could say, "I don't like it when you . . . please stop." and "I don't like that game, lets _ instead." We also taught her that she was well within her rights to say, "No" to anything (including hugs, . . . ) AND there is no shame in asking for help if she needs it.
We invited our daughter to blame us if she needed to. For example,
when she didn't want her cousins in her room, we instated a household
rule that bedrooms are not for play-time. Playing was to happen in a
room where there was an adult present (really not a bad rule for a
lot of reasons when there is questionable behavior involved). She
simply had to say, "I know, it stinks, but house rules and I have to
follow them. . . "
As you are probably already doing, maintain the same consequences for your son you always do where-ever you are. If he argues, but _ doesn't have to do it. Tell it like it is. "That is true. _ doesn't have the same expectations you do. Doesn't change anything though. You know what we expect." No more needs to be said.
Finally, some reassurance
We've been consistent in our honesty, use of "I" messages, and seeking of a balanced approach between letting certain things lay while standing our ground on others for a few years now. Between the kids getting a little older (and calming a little) and our efforts to be supportively respectful of the parents of our nieces and nephews we have actually seen some progress.
Additionally, they are seeing how polite and well-mannered ours is. We can go out to restaurants without total chaos etc. The Mom has even come to me for advice regarding a couple of things her oldest daughter has gotten into at this point. Like you, the first time didn't really seem to have any results, but every time the see a positive interaction between you and their kid, you and your kids, or talk to you about discipline and how you go about it, you are planting seeds - Not all seeds grow, but some of them, eventually will. You just have to give it time.
We also feel that our duaghter is learning valuable lessons about how to look for win-wins and how to hold her own without being judgemental and things are looking up. Slow and steady does win the race - at least at this point it seems to be - so take heart, and good luck. I hope between my answer and the others already posted, you find the right balance of ideas for you and the specifics of your situation.