Oh, what a sad/unfortunate incident! Right off the bat, I'll agree it was bizarre and horrible for this woman to approach you so nastily in front of your small child. Yikes! Completely inappropriate!
As to opinions on how it could have been handled, I admit that I personally probably wouldn't have pushed to go on to the county fair. It sure sounds wrong that the judges are primarily comprised of competitors' parents (why not teachers? or other disinterested parties?), but I still think it is unfair to leap to the accusation that they were biased in selecting the winners. Just by the very definition of "judging" a science fair, there is subjectivity involved, and we can always have our doubts as to the purity of someone's motives, but we can't know for sure.
This is a common complaint in my town ("Susie should clearly have made varsity soccer over Joanie,", etc), but it can just be so hard to say sometimes. But, given that you were at the competition, when she snidely said she was surprised to see you, I think I would have leaned towards smiling back extra-graciously, and saying, "Oh, it's nice to see you, too."
As for what to let your child in on, it sounds like he overheard enough to understand the gist. Since he heard you say to the woman, "It was a little disconcerting when all of the committee's kids got sent on to county.", he knows what you are implying. So rather than tell him that you'll explain in 3 years, maybe I'd give a simplified, toned-down version to him now. But it is a great opportunity to talk about subjectivity, and how some books win Pulitzer Prizes, while some incredibly talented, brilliant literary critics think they are awful, etc. Things aren't always black & white. Beauty is in the eye of the beholder, etc.
Good luck, and I'm sorry you had to go through that!!
