The Player isn't in a dream. The Unchained world is in the Unchained realm, where they relive a series of events from the real Daybreak Town up to a certain point, where they divulge from the original story and avoid the keyblade war.
Essentially, the world fell to darkness when the foretellers fought over dominance and kingdom hearts. Millions of wielders died in the war, and the resulting calamity caused a rift between the world, only partially restored by the light within children's hearts, which split the world into many worlds and made the light realm as it is known today.
Foreteller Ava is responsible for leading the dandelions, a group of confident wielders with hearts of light, into this unchained realm so that they can preserve the tradition of the keyblade and keep the light strong. The unchained realm replays these events so that the dandelions don't even realize what happened, since their memories were wiped, and right when shit went down their experiences shift and are not repeated in the unchained realm.
Your player, however, refused to go with the dandelions, as you feared for the safety of your fellow wielders. You fought in the oncoming battle, and after fending off every foreteller and watching every comrade you ever had die in the horrible battle ahead you laid on the ground and cried with your chirithy. However, before you died, you were picked up by Skuld and Ephemer, who rescued you from the battlefield despite the fact that they weren't supposed to take people from the actual war into the unchained realm.
Now, obviously they couldn't let you live with that knowledge, so you had your memory wiped and your friends are in on it. However, the imprint of the battle scarred your mind, and every night you wake up in sweats thinking about it, how it felt too real, how it had to be real somehow.
So, no, it wasn't a dream. Skuld and Ephemer are lying to him along with Chirithy to keep him safe.
As for Blaine... can't really tell you, Lauriam seems a lot more shifty.