Well that is the neat part, at least for in-game dialogue, hallucinations wouldn't be a problem at all lol.
Your fetch quest example is neat, but what an LLM could provide on top of that is "understanding" and reasoning based on the specific quest. And then commenting if you bring the wrong thing or making jokes. Or even adjusting the quest based on reasoning.
Not sure if you mean the actual uncanny valley, but image / video generating AI definitely can clear it. See this... well it's really badly edited and it's pretty lackluster, but it looks and sounds quite good. Better than 99% of all in-game cutscenes. Just imagine some random quest giver with that kind of animation and voice acting. In a video game this "slop" would be entirely appropriate and a huge improvement.
I'm honestly a bit flabbergasted that people do not see potential in this. Obviously it would still need hardware advances / performance improvements, but it's clear what could be possible.
For rendering, I'm mostly interesting in that "photorealistic look" for characters that AI can do, and there are ways to create a hybrid 3D mesh rendering / generation system. Instead of just generative AI, you render a skeleton animated character but it uses the last step of the AI output and skins that, and it looks as good as AI generated. And that would also improve performance drastically compared to pure generation. I'm not 100% sure this is possible though, but pretty sure. Skeleton animated meshes are a form of compression after all.
On AGI I make no predictions. The big finding from LLMs is that they show that you DON'T need sentience to create intelligence. Which is huge. We can make literal slaves that can intelligently do what we want, can even be creative and are not self aware and do not "suffer" from slavery. Which is perfect for video games. Maybe we should never go further than this until we create something like artificial ethics.