This is a tough call and there are a lot of issues at play here... and you already understand what at least most of them are. And you also understand the root of those issues. Not unexpectedly, you are merely looking for affirmation and support of your stance on the problem or vindication of your past practices. I can give you neither, nor should you feel entitled to affirmation nor vindication. You know your habit of giving in to your daughter's desires has created this 'monster'.
You say you give your daughter too much, and this is understandable. You love her and dote on her and want her to be happy, right? Bear in mind that happiness is a journey not a thing. And in order for your daughter to understand and achieve happiness she cannot attach that to things. You will do her a world of good just by helping you both learn that you don't need things to be happy and doing things to make others happy, especially those closest to you, can help make you happy too. In this case, that would be her grandfather.
It's time to sit your daughter down and explain to her that what she did was wrong. Her grandfather was very hurt by what she did and said and that was a cruel thing for her to do. - Yes, it's okay to tell a child they did something cruel! You are not saying the child is cruel or not nice, you are saying what they did was cruel or not nice and it is important to make a clear separation between the two concepts so the child understands you are not calling her bad or cruel or not nice. So tell her what she did was wrong and explain to her WHY it was wrong. Tell her you know she loves her grandfather and that she would not want to deliberately hurt him so she needs to apologize to him and thank him for his gift. Now is a good time to start helping her learn compassion for others. Explain to her that gifts are something that comes from the heart and people are not required to give gifts, they do it because they love you and care about you and, when she insulted her grandfather, she was, in a sense, saying she didn't love him! Ask her how she would feel if her grandfather told her he didn't love her and never gave her any gifts. That would hurt her a lot, I am sure. And, seeing the situation from the 'other side' can help her to understand how her actions made her grandfather feel.
NEXT big step is to stop giving her so many THINGS! Even at her young age, it is not too early to start getting her involved in modestly philanthropic endeavors. If she gets an allowance, have her put a certain percentage of that aside to donate to charity. Explain to her that there are many people who simply do not have all of the things she does. There are children around the world who don't have any toys at all. If she has been isolated from news about the earthquakes in Haiti, now might be a good time to talk to her about that and ask her what she thinks your family can do to help the children in Haiti. Contact the nearest orphanage/children's home about having your daughter come to visit the children there (some are more amenable than others to such visits). If your community has an annual clean-up campaign, join in and get your little one involved as well. Or take her with you and volunteer at a local soup kitchen or church/community 'clothes closet for the needy' store. There are always scads of opportunities for volunteerism and getting your daughter in touch with her relative wealth of privilege and the concept of giving back to her community can help her to appreciate her good fortune. Engendering this sense of sharing her wealth will not only help her to appreciate what she has but will stand her in good stead as she gets older.
Now ... stop buying your daughter toys. If she has not learned to appreciate them, she should not be entitled to them. (My daughter once told her son that he would not be getting any toys from Santa for Christmas because he had too many already. (He was about six at the time.) He picked his favorite toys from his overflowing toy box and the rest were put into a yard sale, the proceeds from which went into his bank account. Those that did not sell, he took (with Mom, of course) to a charitable organization for distribution to less fortunate children.) Don't give her toys, give her hugs and kisses, and tickles and one-on-one time to DO - like fingerpainting (remember that?), and baking cookies or brownies (and take some to Granddad to help say, "Thank you and I'm sorry I was rude and hurt your feelings and I really do like the teddy bear.")
There is nothing wrong with taking (not throwing) toys away from a child for a period when they misbehave. This is no different from someone losing their driving privileges when they have too many violations. You break the rules, you pay the price! She needs to learn this - gently - from you, or she will cause problems for herself later in life. But bear in mind, you did create this problem so you will need to be very cautious about how you deal with the resulting behavior. That doesn't mean you can just say, 'It's my fault so I don't have to correct her for it,' You DO have to correct her for it or she will never learn better behavior and you will only be compounding the problem for the future.
Does your daughter have a tv in her bedroom? If so GET RID OF IT! Do you read to her? Instead of buying toys, which often end up getting tossed aside, broken, and/or ignored in the bottom of the closet, buy books. Up close and personal time with a book - reading to her and (eventually) her reading to you, will not only strengthen your bond with your daughter, but it will help her to learn to read, expand her vocabulary, and make her a more confident, secure human being. Some of my favorites are Sesame Street books, especially "The Monster at the End of the Book". Seuss books are simply a treasure everything from "The Cat In the Hat" and those Sneetches (with or without stars on thars!) to my favorite gift to new parents, "Oh! The Places You'll Go." Shel Silverstein's "The Giving Tree" is an absolutely priceless addition to any bookshelf. (You may have caught the 'real' Giving Tree story on your local news last week!) Other good books to add to the bookshelf are Silverstein's poetry such as "Where the Sidewalk Ends", "Runny Babbit", "Falling Up", "The Missing Piece", "A Light in the Attic", "Who Wants a Cheap Rhinocerous?" ... The seemingly endless collection is full of entertainment and life lessons for both kids and their parents.(Although the world lost the gift of Silverstein's ongoing brilliance, there is still a website dedicated to his work and aimed at parents and educators. Check it out at: http://www.shelsilverstein.com/html/home.html ).
The bottom line is, don't let your daughter, or you, mistakenly equate things with love - the bigger the bauble the larger the love - kind of thinking can only make her unhappy in the future when the world does not live up to her expectations and greed. (Yes, GREED! Because that is what you have, heretofore taught your daughter through your mistaken gestures of love.) It's natural to want to give to our children, to see the joy and excitement in their eyes and to hear the magical, almost saintly sound of their laughter. That is what makes it so easy to overindulge them. We are selfish. It brings joy to us and it feels good to feel we are giving them joy. On the other hand, it is not easy to change a 5 year pattern. In fact, it will be down right tough. But the good news is, you have identified the problem. That's the first (GIANT) step. It's not too late for either of you and you will, in the long run, find the results so much more satisfying and rewarding for both you and your daughter ... and her grandfather. And she'll thank you for it when she gets older. And, btw, giving her a safety net to allow her to try new things and, sometimes, fail, but do so without fear of ridicule, will give her the confidence she needs to continue to try new things and learn new things and have faith in her own abilities..
Who knows? With a new approach to loving and teaching your daughter, you may be raising the first woman president of the United States! Or a multi-billionaire philanthropist praised the world over. With the right tools, anything is possible. (And be sure to teach her that, too!)
Good luck