The name of the story you are referring to is The Last Stand I believe it is"The Last Stand" book 37#37 in the Next Generation Series. I believe it is Worf who feels they are being spied upon and Picard makes the suggestion to talk in "code" based on human fairy tales. This of course resembles how the people in the episode of Darmok communicated with the federation:
“Excellent,” Picard said, nodding. “Counselor, Lieutenant, do you recall our good friend Dathon?”
“Why, certainly, Captain,” Troi replied. “Didn’t he have two good friends, Darmok and Jalad, who met at—”
“Tenagra,” Worf finished. “Yes, I remember them all quite well. They were to be emulated.” “Yes, they were,” Picard said. “They were fine role models for Starfleet officers. Actually, I think of them quite often. I recall especially well their story of how Pinocchio’s nose grew during his time inside the whale.”
Both Troi and Worf nodded. It was helpful that both of them had been raised by at least one Earth parent, and so each had a working knowledge of some of that faraway world’s more celebrated myths and legends......
.......And then shortly afterwards.....
“What is this gibberish?” Hek fumed. “Pinocchio? What in hull is a Pinocchio? Aren’t these people ever going to talk about anything important?”
“No one ever speaks about anything important in the reception lounge,” Drappa said. “It’s too thoroughly monitored for that, and everyone knows it. I don’t bother my people about it anymore, except in special circumstances. Presider, either these people from the starship are mindless idiots capable of speaking of nothing but old stories, or they’ve assumed they’re being monitored and are speaking in a kind of code.”
“Fine, then. Break it.”
“Oh, we’re trying,” Drappa said. “Our best cryptographers are already working on it—but they have no chance of success, Presider. The code clearly depends on cultural references with which we are not familiar—”
