It's hard for me to judge the true nature of the original situation, as I wasn't there and we're only hearing one side of the story. (To misternada: Mind you, this doesn't mean that I doubt the accuracy or veracity of your account, just that I don't feel too comfortable extrapolating too much about how extreme her reaction was as compared to your response.)
I will say this: I've found that these sort of experiences and encounters have happened to me less and less as I've spent more time here and gotten more comfortable with the language and culture. This is not to say that subtle racism and microaggressions and whatnot do not exist in Japan at all (they most certainly do, and in the case of the latter, they are not targeted solely toward foreigners), but extreme, outward displays of hate, fear, or hostility are not something I encounter regularly (or, at all, really) these days.
Thinking back, I have to agree with Majestic when he says that these things happen more often when you're (consciously or unconsciously) "looking for them". I do remember a time when I was younger and more self-conscious and insecure about my language ability and my place in Japan (and honestly, more self-conscious in general), and there was probably a degree to which I had a chip on my shoulder and this underlying feeling (not overpowering, but just something that was there beneath the surface) that I was being judged, ostracized or what-have-you. When you're carrying that feeling with you, it's "easier" to see the world through that prism, and that can, at times, become a self-fulfilling prophecy.
(Again, I'm not saying that things didn't happen as you say they did, or trying to "defend" some woman I don't know. She could indeed have been mentally disturbed or deathly afraid of foreigners for some ungodly reason. In that case, I would have to agree that confronting her in an intimidating way probably isn't the best way to resolve the situation. If you felt the need to say anything or convince her that you were a good person who speaks Japanese, a gentle どうかされました? or 大丈夫ですか? would probably be more effective.)
Majestic said:
My Japanese is pretty good, JLPT1 and translator's certificate and all that, but I don't insist that everyone speak Japanese with me. In fact, with each passing day I realize how poor my Japanese actually is. And I can tell that yours isn't as good as you think it is either. The sooner you come to peace with this, the better your life will be. If I'm on the phone or the internet, and I have a choice between Japanese and English, I choose English because its my native tongue. If the English of the person (or the site) on the other end isn't sufficient to get the information I want, I switch to Japanese. If the person on the other end wants to speak English, or insists on speaking English, that is OK with me. The constant need to "mount" the other person to show or prove that you have Japanese chops is something that needs to be discarded as quickly as possible.
I also agree wholeheartedly with Majestic with the idea of "leaving your ego at the door", so to speak, when it comes to Japanese ability.
That said, I can't quite get behind every sentiment here (especially the bolded ones). I don't see a need to default to English just because it's my native tongue, nor to entertain every Japanese person who wants to practice their English on me. I have no need to "mount people" to prove my chops, and am more than happy to converse in English with friends or acquaintances who are clearly interested and/or invested in the language, but if somebody refuses to acknowledge that I can function as an educated adult using their language, I will (diplomatically, of course) stand my ground.
It's not about "mounting" the other person or having some burning need to "prove my chops", but rather just about expecting a certain level of respect as a human being. I've found that if I'm confident, polite, and friendly about it, 99% of people are perfectly happy to talk to me (even when I'm in the company of my wife or Japanese friends), and this has gone a long way towards helping me take the aforementioned chip off my shoulder, as I know that the occasional ******* is the exception rather than the rule.