Hi there,
I have a dog with the same potential problem yours might have. My GSD Pharoah (posted under GSD photos)will kill most things that are smaller than her. Opussoms, raccoons, birds, rats, rabbits, she has a very strong preditor instinct. We have tried to break her of that habit but it hasn't worked in the 10 years she has been on this earth.
I dog sit a small chiuawa (can't spell!!) and once she accidently ran into Pharoah's chain length and Pharoah tried to kill her. As soon as I yelled she let her go. But the potential was there. Just took one second of not watching the little puppers and the outcome could have been a lot worse. Not all dogs can be taught to deal with something smaller than them if there kill instinct is strong, even though a lot of people say you can. Every dog in the world hasn't been tested against it. She also hated Brutis when he was a puppy, she growled at him, raised up her hair but never put him in her mouth like she did to that small dog. Small as in maybe 3lbs.
I would do the lattice thing to keep the small dog out. Lattice isn't that expensive and if your neighbour chuckled about your dog attacking her small dog, I'm sure she won't pay for it either. But deffinatly your dog will look like the bad guy if anything does happen. It all depends on if it happens and if she wants to push the issue. In Canada I've heard of people suing another person if there dog enflicted wounds that required vet care to another animal. I guess the courts see that you are responsible for the actions of your animal, that could get very costly. I can't believe she chuckled about it. Even if she is a great neighbour and a good person, that isn't responsible dog ownership. You were trying to be a responsible dog owner stating the fact that something could happen and she blew it off.
I guess thats the simplist thing to do. I have tried to introduce Pharoah to other small dogs including puppies, let her smell them and the whole deal, but when your not there you can't predict what Kana will do. I'd hate for Kana to look like the bad one in this situation. Hope I helped a bit