A hallucination is seeing something that is not there. This can be due to a mental illness or the taking of drugs. In video games, hallucinations are generally caused by drugs. The character starts seeing things and when he approaches them they may disappear. Hallucinations can be entire levels like in Batman: Arkham Asylum where the Scarecrow sprays you with gas that makes you go on crazy dream levels. In games like Silent Hill, hallucinations are a result of a mental illness.
Even if what you're seeing doesn't exist, you can still die in your own hallucinations. Hallucination levels are usually weird and confusing, sometimes representing the character's inner fears.