"She is reading."
They're both said the same way in German.
When translating into English, either will usually be accepted unless the context makes it clear that it is a repeated or habitual action or something that is taking place right now, in which case the rules of English will tell you which tense to use. (e.g. ich singe jeden Tag ein Lied will be "I SING a song EVERY DAY" while ich singe gerade ein Lied will be "I AM SINGING a song RIGHT NOW".)
You look at the subject:
- ich lese (I am reading)
- du liest (you are reading - one person whom you know well)
- er, sie, es liest (he/she/it is reading)
- wir lesen (we are reading)
- ihr lest (you are reading - several people whom you know well)
- sie lesen (they are reading)
It's never leist.
The infinitive is lesen so the verb stem is les-.
Verbs with a stem ending in -s, -ß, -z, -x simplify the -st ending: -s-st, -ß-st, -z-st, -x-st become simply -st, -ßt, -zt, -xt.
This verb is one of those that change the stem vowel for the du and er, sie, es forms; in this case from -e- to -ie-.
So you have du lies-st simplifying into du liest while er lies-t is er liest, and the du and er, sie, es forms end up looking the same -- but different from the ihr form which has no vowel change and is thus ihr lest.
(Compare du trinkst, er trinkt, ihr trinkt where the er, sie, es and the ihr forms are the same as both simply add a -t.)
How come "Sie" is they and she?
Because of sound changes.
They used to be merely similar, with a different final vowel, but when unstressed final vowels turned into -e, the two ended up sounding the same.
Something similar happened in English with "he" and its plural, only this bothered the English speakers so much that they decided to borrow the word "they" from their Norse cousins.
what is specifically wrong with "sie ist liest"?
The word ist does not belong in that sentence.
You can't just put an extra helping verb in just because you feel like it, as in "She does is reading" or Sie ist liest. The result is nonsense.
She is reading. = Sie liest.