I'm being brutally honest. Now, let me make it clear that I would not have said the words, "Well, I guess that popped his balloon when you pointed out what with a mother who looks like his, he's in no position to be putting down anyone else's mother," nor would I have said the words, "Thanks for sticking up for me by giving that kid a verbal smackdown." But I would have thought them. I can't help that.
And on the INSIDE......Yes, I'd be relieved that DD had the intestinal fortitude to look him in the eye and not put up with that crap. I don't think it's sinking to his level to take on a bully and shut them down. In my childhood experience, sometimes the ONLY way to get someone who is pulling this stuff is to give it right back. Yes, a child could take the high road and ignore the insulter while even more insults are hurled. They could say, "You're being rude and that's not nice." But the insulting child is fully aware they are being rude and they do not care. It is their intent to be less than nice. The child in question was being verbally bullied, albeit via an insult to his mother.
I had experience with a bully that intimidated our class (both boys and girls) for years. Normally, I was a kid who liked to have fun and had lots of friends. I was never in a fight and to this day, have never been in one. But on the day I stood up to her and said the equivalent of, "Bring it on...I've had enough of you," and she backed down, I learned that what adults had said for years was true. Standing up to a bully may just be the best way to get them to leave you alone. Sure, they may give you a beatdown...

....And I was prepared for that. I'd just had my fill of her. But I was going to give as good as I got. However, when someone FINALLY dished out to her what she'd been giving to them all those years, she crumbled.
So did the little insulter in this story. Kid #2 returned with a "yo mama" and the insulter ran crying back to his mommy. Clearly, he expected to toss insults at others, but be immune to the same treatment. Now he knows better. If the school had either stayed out of it OR given the same punishment to both kids, the insulter would have learned that in the future, messing with that particular kid might not be so much fun. Sadly, because the school fubared it, the insulter has perhaps failed to learn that lesson.
I don't like bullies. Bullies get to be bullies because they get away with things over and over and over and no one calls them on it. So they begin to believe that their behavior is acceptable and is their right. Every once in a while, someone needs to come along and burst that bubble. Was Kid #2 being especially NICE when she retaliated with an insult to the insulter's mother? Noooooooo, she wasn't. She didn't exactly behave like a little angel. But then again, she wasn't dealing with a very nice person, was she? I truly don't think taking the high road or turning the other cheek with a kid who will insult your mother RIGHT IN FRONT OF another mother is going to accomplish a lot. Any kid who will mouth off like that when another mother is present has no problem bullying.
I guess we'll have to agree to disagree. I just don't think trying to be the bigger person where a bully is concerned usually pays off. I think it usually just leads to more of the same. As for the mom canceling the birthday party, either she is seriously overreacting or there is a lot more to the story/this kid's history.
I doubt Kid #2 was making any kind of religious commentary. A child insulted her mother by calling the mom weird and ugly and so Kid #2 pointed out, from her 7 y.o. point of view, that the insulter's mom dresses crazy. (Actually, that's just one insult against the original two.

) Most 7 y.o.s do not grasp the religious reasons a person may dress in a way that is outside the norm.....They just know it looks unusual/crazy.
From a 7 y.o.'s point of view, I'd say the insult of "your mom dresses crazy" is much less harsh than "your mom is weird and ugly." The problem is, I don't think the adults are bothering to look at the situation from a child's point of view, but are instead projecting all sorts of "stuff" into it that just isn't there.
If my DD came wailing to me that some kid had insulted me (her dear mother) and I found out that she had initiated the whole incident by first insulting
that child's mother, she'd be the one in trouble. I might not be thrilled that some kid insulted me

but I'd certainly understand why he/she did so. Lesson learned for DD: Don't go around insulted people's mamas.
Here's how it might have gone if the insulter's mother hadn't ran crying to the school herself: (Do I sense a trend?)
Insulter: Wah! Little Janie said you dressed crazy. She's so mean!
Mom #1: Let me call her mother and straighten this out. She can't get away with that. Hello.....Janie's mom.....My little sweetie just ran home from the bus stop crying because your mean Janie said horrible things about me. She made fun of our religion and said I dressed crazy.
Mom #2: Oh....Did he also tell you he first said to Janie that her mom, meaning little old me, was weird and ugly? Once he said that, I'll admit she got a little testy and you mama'ed him. But as you can see, there is more to this story than your son told you. I tell you what. I'll handle Janie on my end and you handle your son on yours.
Now Mom #1 has a choice to make. Will she coddle her sweetie and let him continue to bully others or will she tell him that when you say mean things to other kids, there's a good chance they're going to be mean in return and that he might want to rethink the insults in the future?

As of right now, from what the OP indicates, the insulter has been given the idea by the school and his mother, that he did no wrong.