That being the case, I'd dare her to do it just so she'd make herself look bad lol. Like the first commenter said, she wouldn't wanna make her case in front of a judge.

Let me get this straight. This is your "friend" we are talking about here?

Hmm....tell her no.

Tell her that she wouldn't have the honor of being any character in the book, much less the insane goblin witch. I wrote a novel and never published it or anything, but my friends begged me to make a character based on them. She isn't your friend, ditch her, don't look back.

I'd take it as a compliment that she thinks your book is good enough to be published and would be successful enough that any royalties would be significant enough to be worth suing over before a single copy has been printed. Even an insane, ancient goblin queen would have waited for you to reach J.K. Rowling/Stephanie Meyer level of success before threatening to sue.

Okay, this is a stretch but run with me on this. First get this woman drunk, real drunk. Then put on a horse costume. You know, the kind of horse that would have sex with an ancient, insane goblin. When she sobers up, tell her you've been inspired to rewrite chapter 2.

Just tell her you won't publish it (since royalties are made by publishing it) then tweak the villain, just in case.