Silent Hill is a deliberately confusing game but there does seem to be some underlying order to it. While I’m sure other people have different interpretations of what is happening, this is what is going on based on my play of the games and what I have found on the 'net.
To answer your questions in no particular order.
There are really two Silent Hills (or maybe three, depending on how you count things). There is the real Silent Hill; a nice vacation town located somewhere, and then there is the “Twilight Zone” version of Silent Hill, which is where the games take place. I’ll call this one Shadow Silent Hill.
Shadow Silent Hill has two forms; Misty Silent Hill and Dark Silent Hill.
Silent Hill has a very dark and bloody past. Even the native American tribes who lived in this area treated this as an evil place. Something about the area seems to encourage evil and murderous acts.
During the American Civil War, there was a Union prison in the town. Most (if not all) of the prisoners there were tortured and executed. The guards at the prison wore pyramid-shaped helmets and executed the prisoners by impaling them on spears. These are the “weird pyramid-headed guys that keep showing up” and the prison is the one you spend some time in. The paintings and some of the writings you find are from the prison and explain a bit of its history.
At some point in the history of the town a cult arose which worshipped the evil demon “Samael”. At one point the cult attempted to bring Samael physically into the world in the form of a child born to the cult priestess. Unfortunately for them, only half of Samael was born into the child. Later, a second child is born with the other half of Samael.
With Samael in the world, Shadow Silent Hill came into existance. Misty Silent Hill and Shadow Silent Hill are creations of the two halves of Samael.
(I won’t go into more detail here since this is a major part of the plot of the first game.)
When certain types of people arrive in Silent Hill, they will find themselves in Shadow Silent Hill instead of the real Silent Hill. These seem to be people who have either done actual evil themselves in the past or people who are strongly conflicted within themselves. Sometimes, other people may get “pulled along” with these people when they arrive.
This is why there are almost no people in Silent Hill; this isn’t the real town.
The monsters and the like are creations of Samael and Shadow Silent Hill and represent the conflict and turmoil within the visitors. Not everyone who finds themselves in Shadow Silent Hill will see monsters and, if they do, they may not see the same monsters. The town also seems to have the ability to create “people” who can interact with the people who arrive there; apparently attempting to cause those in conflict to come to a decision. Probably the wrong one.
Now, some specifics. James Sunderland and his wife Mary have apparently visited the real Silent Hill many times in the past. Mary has contracted a degenerative disease which will kill her in three years. She is staying in Silent Hill, apparently because the environment makes her feel better and helps her condition some.
James cannot stand to see Mary dying and, partially out of mercy and partially because he does not want to be tied to an invalid for the next three years, kills her. Mary did not die three years ago; she died fairly recently. This is the conflict and act which causes James to be pulled into Shadow Silent Hill.
Maria is a creation of the town and exists to confront James with what he did. Like Mary, she is sick (notice her coughing and the pill bottles beside her bed when she rests in the hospital), but she is also very sensual (and has the key to the strip club in town), the thing that Mary could no longer be after she became ill. She dies several times in front of him, reminding him of what he did to the real Mary. How James treats Maria is one of the major things which determine which ending of the game you get. (You do know there are four possible endings, right?)
Also notice that most of the “monsters” James encounters are either deformed female figures or deformed nurses; both symbolic of Mary dying in a hospital.
Here’s something to try… Remember the letter and picture of Mary you have at the beginning? Don’t look at them after the beginning of the game and spend a lot of time with Maria; talk to her whenever possible, check in on her when she is sick at the hospital and so on. Then, later in the game (after crossing the lake when I played), look at the letter and picture. They will be blank.
Laura was a friend of Mary’s while she was staying at the hotel and apparently spent more time with her while she was ill than James did. (She confronts him with this several times.) She may be the real Laura, pulled into Shadow Silent Hill by accident. This is why she doesn’t see any monsters and why a small girl can run around town safely. Or, she may be another creation of Silent Hill that exists to confront James further with the way he treated his wife.
As for the others; they are visitors to Silent Hill like James. Angela was apparently abused by her father as a child. At some point she apparently killed him. For some reason she blames herself for this and this conflict is what has brought her into Shadow Silent Hill.
Eddie has felt that everyone is always laughing at him or making fun of him. He may have killed someone for this before coming to Silent Hill. At any rate, instead of monsters he sees people who laugh at him and he is killing them.
Is it a dream? Well, there is some question in both games as to if the characters are really in Shadow Silent Hill or if everything is simply taking place in their minds. Different endings seem to imply different answers.
There is also a theory that all of the characters have just died and Silent Hill is some sort of test for them before final judgement.
Would playing the first game help things make more sense? Not really. If anything the first game is more confusing than the second and things do not seem to be completely consistant between the two. I thought the first game was creepier than the second, if that means anything.
As I said, there are probably other interpretations out there but this is the one that seems to make sense to me. Hope this clears things up a bit.