Anand D. Shah wrote:
Buddhism says life is an illusion
Only Mahayana ( Great Wheel/ Japan, China,
Tibet,..), not Theravada ( Sri Lanka, Thailand,
For Theravadins, life is real.
How do we know that the phenomenal world that our conscious lies in is different than the dream world that our unconscious and collective conscious lives in? Is it one illusion on top of another on top of another?
In Mahayana, you got two chief schools: Yogacara and Madhyamika. I'll give a brief answer according to Madhyamika, with its Trikaya doctrine as assimilated in Vajrayana/Tibetan Buddhism. Detailed expositions can be found in Govinda "Foundations of Tibetan Mysticism", "Bardo Thodol/Tibetan Book of the Dead"; also, http://www.buddhanet.net/filelist.htm.
According to the Trikaya, "world" is Svabhavikakaya, "composed" of Dharmakaya ( Absolute/"The Body of the Doctrine" - identical to Vedantist Atman/Brahman or the Sufis' Dhat/Hahut ), Sambhogakaya ( Absolute in blissful manifestation/ "The Emanation Body"- identical to Vedantist Atman in Anandamaya kosha or the Sufis' Lahut ) and Nirmanakaya ( Absolute in the manifested worlds/"The Transformation Body"- identical to Vedantist "subtle" (Vijnanamaya, Manomaya, Pranamaya ) & "gross" ( Annamaya) worlds or the Sufis' Jabarut, Malakut & Nasut worlds/dimensions of Reality. )
So, in Mahayana Buddhist perception world is not just an illusion, mirage ( although they stress this frequently in order to loosen the grip of sensuality on an initiate ). It is manifestation/emanation of more "essential" reality of Dharmakaya.
What are dreams ? They are, according to Bardo Thodol, experiences of consciousness ( mano-vijnana ) in Bardo world (essentially, a dimension of Nirmanakaya or Vedantist "subtle" world ), where consciousness enters in dream or after-death state. One is then subjected to various visions emanating from his mind ( manas ) & thought-forms/beings residing in the Bardo. Govinda has elucidated in pt.3, ch.9 of his book ("Foundations") various dimensions of consciousness ( "dream-consciousness" is rmi-lam bar-do ).
So, in short: Bardo, or "dreamworld" Nirmanakaya dimension in illusory reality, is the "place" where dreams and after-death experiences occur.