For iMessage to work, it has to be enabled in settings on both phones (Settings > Messages > iMessage > On). Is your sister-in-law's phone iMessage enabled?
If your wife shows up twice in Contacts, someone created 2 separate contacts entries. If your wife's phone isn't set to receive iMessage at a phone number, but is for email, sending to a number will go as SMS.
Settings > Messages > Receive At > sign out of Apple ID to receive iMessage only via phone number (and show number in "from")
Not sure about my sister-in-law's phone. I havent used iMessage with her before. My wife's is (or was...) definitely set to ON. We have used it for a month. Just all of a sudden everything is text and it doesnt even show iMessage as available when I chat with her. I will dig in to her settings tonight to see if somehow it got switched to OFF.
About her email and phone both showing up when I search contacts to start new chat... She is only listed once. That one listing has both email and phone in it, as do many others. However she's the only one I have seen so far show up twice like that.
Also, I did a hard reboot of my phone. iMessage now doesnt even show available on her email address like it did before. Sigh. Theres been some weird juju going on with this phone since i got it as a replacement in Feb. Like sometimes I will be watching a movie, pause it, and when I click the headphone clicker to start it again it actually starts playing my iPod music, leaving the movie paused. Weird stuff like that.
"hard" reboot, "hard" reset - no such thing in iPhone terminology, and only confuses noobies. "Hard" vs "Soft" restarts, reset, reboots are obslolete (1980s) PC terms
See the User Guide, Appendix B: for iOS troubleshooting steps.
Theres been some weird juju going on with this phone since i got it as a replacement in Feb.
If all else fails, try one of these: