Little Diamond is dreaming:
It was such a nice stair, so cool and soft - all the sides as well as the steps grown with moss and grass and ferns! Down and down Diamond went - a long way, until at last he heard the gurgling and splashing of a little stream; nor had he gone much farther before he met it - yes, met it coming up the stairs to meet him, running up just as naturally as if it had been doing the other thing. Neither was Diamond in the least surprised to see it pitching itself from one step to another as it climbed towards him: he never thought it was odd - and no more it was, there. It would have been odd here. (At the Back of the North Wind, Ch. 25, "Diamond's Dream")
George MacDonald's novels are made of dreams. Every time the North Wind comes to see Diamond, she has to get him out of bed, and somehow he always ends up back in bed, or nearby (he perhaps sleepwalks) when the adventure is over. It was all just a dream. Or not. MacDonald won't say. The passage with which I began is unusual in that it is explicitly a dream, about a bunch of naked angel boys who dig up the stars every night. What? Who knows, it's a dream.
The hero of Phantastes wanders through a magic world that is a mix of German novellas, King Arthur stories, and actual fairies ("From the cups or bells of tall flowers, as from balconies, some [fairies] looked down on the masses below, now bursting with laughter, now grave as owls", Ch. III, which is full of fairy lore).
I found Phantastes too strange, too random, and in some sense, then, not so like a dream. The later Lilith, however, perfectly mimicked dream-logic. I cannot explain the difference. The weird hodgepodge of Biblical apocrypha and dancing skeletons and tiny elephants and a librarian who is actually a raven (or vice versa) somehow all seemed to fit together. The illogic of Lilith is more logical than the illogic of Phantastes. Or less logical. Who knows. One scene near the end of Lilith is exactly like a recurring dream I have had for years, which is just too weird, or else completely understandable.
Since I'm on the topic, readers of Neil Gaiman's Sandman series really must take a look at Lilith, obviously a touchstone book for him. Certain passages were uncannily like bits of Sandman. And I haven't written a word, and might not, about MacDonald's less dream-like fairy tale mode, as in The Princess and the Goblin (please see raych's enthusiastic enthusiasm), which I could imagine many readers preferring to the Ludwig Tieck-like dream-space of Lilith.
Update: Look, here's Things Mean a Lot on the joys of The Princess and the Goblin, hot off the presses.