I recently read a news article on the Codex where some developer talked about the most important features for making a gameworld seem alive. He said unobtrusive interfaces and NPC schedules are the two things that have the greatest effect on immersion.
Well, I call bullshit on that one. Especially the "unobtrusive interface". What's the point? Some of the most immersive games I've played had quite complex interfaces and I didn't mind them even a bit. NPC schedules can contribute a lot to immersion, but aren't the most important thing.
Most important for making a "living and breathing" gameworld is the design. Make it logical. Make it consistent. The game feels alive when the player thinks that such a world could, theoretically, exist. If there are many plot holes, silly design decisions and just plain bad design, the world feels artificial and the immersion-level goes down the drain. Just take a look at Fallout 3. It's been hailed as very immersive, and, yes, some parts of the game are indeed immersive - but this immersiveness is immediately killed when you discover, for example, a quest involving two super-heroes fighting each other in some town. It's supposed to be a dark and gritty post-apocalyptic setting, and then you get a bunch of silly-dressed superheroes fighting each other? That's just plain ridiculous and ruins the impression of playing in a realistic setting. There are other occasions like this, and they work wonders in ruining the immersion. You can't feel immersed in a setting that doesn't make any sense and is inconsistent as fuck.
So, first lesson in making your gameworld live and breathe: make it consistent, logical, don't include unfitting things just because you think they're cool. I usually make this mistake too when creating new settings, but then I read through it again and strike out everything that makes the fantasy world seem artificial. Making a game-world consistent is hard. It's easy to think up individual elements that would be cool/awesome on their own, but are totally unfitting in the kind of setting you're trying to create. Don't include them. Or at least adjust them so that they make more sense in the context of the setting. Also, try thinking up reasons for why places exist and stuff happens. Why is there a ruined tower in the wilderness, and why is it full of undead? Put some journal on a dead soldier in the dungeon which can be found by the player. The journal explains how the undead conquered the tower. That's a little detail that adds a LOT to immersion. I'm going to talk about details later on in more, well, detail. Also try to give the evil guys some logical motivation, a reason why they want to destroy the world. Arcanum did this really well. Generally, just put some thought behind everything you put into the gameworld and you should be fine. Not just "I think this would be cool, let's add it to the game!", but "Before we add this, let's think how we can properly include it into the gameworld."
A logical, consistent setting is the most important factor for making the game immersive. But it's not the only one. There are also smaller factors that can substantially increase the immersion-factor and make the world feel real. I'll just refer to them as "details". Details include background information, NPC schedules and level-design. Let's talk about background information, first. This is mostly composed of history. General history of your fantasy world, mythology, background information about certain places and so on. The more detailed the world's history, the more real it seems. Going into a library in the capital city and finding lots of books about the country's history makes it seem like a real country. The Elder Scrolls series did this really well - there are countless books to discover and read in Daggerfall, Morrowind and Oblivion. Morrowind did the whole "background information" aspect perfectly. The gameworld had lots of historical information, different cultures, an interesting political situation... it seemed realistic because there was a lot going on in the past and there's still a lot going on when you, the player, arrive on Vvardenfell.
NPC-schedules are another detail that can add a lot to immersion. Morrowind's world was very immersive, but it didn't feel "alive" because all NPCs did was stand around staring at walls. Good examples for NPC-schedules that did their job well are Ultima VII, the Gothic games and The Witcher. NPCs went to work, went to the pub in the evening, and went home to sleep at night. Making your cities seem alive isn't even a lot of work. It can all be done by simple scripting. Give each NPC a daily routine and voila, they look like real people living a life. It doesn't even require a complex AI, just some simple scripting. Heck, Ultima VII could do it and that game has been made in 1992.
What Ultima VII also does well is world interaction. You can even bake bread! Generally, every item has some use. Not directly a gameplay use, but you can play around with everything. Fill a bucket with water, harvest grain... it doesn't really add to the gameplay, but it does add to the immersion-factor. Things in the gameworld actually have a use instead of just being decoration.
That's where we come to level-design. Decoration is important there to make the world feel real. Houses should be filled with decorative items (depending on who owns the house, of course - rich people have more expensive items than poor people). Dungeons shouldn't just have hallways and rooms, but should have some items in there that show the function of the room. Torturing tools show that the room once was a torture chamber, cooking tools that it was a kitchen and so on. Decorating the places in the game makes them look more real, which is good.
So, in the end, there are many factors that make a world feel alive, but most of them are just minor details. All those details don't help if the setting is inconsistent and consists of "themepark" locations and places/quests that were added just because someone thought it's a cool idea. Get your gameworld right and only *then* you should think about things like NPC-schedules.
Also, while I generally think that the perspective and interface don't matter much, 1st person or behind-the-shoulder 3rd person seems to generally be more immersive than isometric. But I don't give a fuck about interfaces. Good, immersive games are complex. Complex games need complex interfaces. I also don't care if there's a health-bar at the bottom left in my first person view. Some people say that truly immersive games shouldn't have any visible stauts bars in first person view. I don't even notice those bars if they're small enough, but I wouldn't want to miss them- they offer useful information about your character and should stay where they are. "Unobtrusive" interfaces aren't important at all to make the game immersive. Good world design is.