I agree with first seeking a medical opinion to rule out any physical issues. I will say lot of the issues around sex are really psychological. I think the difficulty that Catholics and other Christians have is that we have been wrongly taught the tenants of our faith that pertain to sex to the point we have made sex taboo and this sort of dirty thing to be avoided. Rather if you look at the teachings yourself, particularly Pope John Paul II’s writings, sex is a beautiful thing given to us by God, and those who are united before God in marriage are encouraged to be “fruitful and multiply.” Sex is a good thing in and of itself. The reason the Church prescribes that it be done in a marital context is because that is the only context that the sacredness of sex itself is respected and maintained. The dignity of both persons is recognized. It seems like your wife might be facing some sort psychological trauma possibly from an experience herself or having been wrongly taught that sex is a dirty and taboo thing which unfortunately plagues a lot of Catholics. If you read the teachings yourself you will find nothing wrong with them but upon reflection more often than not you will that the Church teachings have been wrongly taught and applied. I highly recommend reading John Paul’s theology of the body and Love Matters. He is perhaps the most insightful pope and author into the human experience. We often scoff at the idea that priest know anything about sex however we must remember that priests are often the people that are often told the things couples don’t tell or struggle to tell to their spouse so sometimes a priest may know more about the marriage than the couple themselves. I would suggest talking to priest that you trust and that you believe can be insightful on these matters. Talk to the priest together but also separately if need be. Understand that from a woman’s perspective sex is approached very differently given that at least at a sub-conscious level married women have this sense that their worth as a woman is tied to their ability to bear children and please their husbands similarly a man’s sense of worth is tied to his ability to protect and provide. This is just part of human evolutionary history (no I don’t believe in Darwin) and how God made us to an extent. However we can’t lose sight that you, your wife have inherent human dignity regardless of your ability to provide or her ability to have joyfully have sex and bare children. Relax and take comfort that God knows all your troubles, worries, hang ups and what’s causing them more than anybody. I highly recommend you to church when there is nobody there as a couple, stand before the altar and surrender your worries and everything to God (it all belongs to Him anyway) and trust in Him. Do not expect anything from this temporary life good, bad or otherwise other than for God to do things beyond your imagination.
Don’t give up and don’t think annulment… marriage is much, much more than sex. And sex can be learned and improved. Find out WHY she is scared. And go from there.