Non-player characters (NPCs) play a crucial role in shaping player experiences in narrative-driven games. This study investigates the potential of AI-driven NPCs to elevate player challenges, foster skill development, and deepen emotional engagement. Focusing on adaptive conversational agents, we explore how dynamic, context-aware dialogue systems can enhance player immersion and agency.In our experimental 3D RPG prototype, Down the Rabbit Hole, AI-powered NPCs respond organically to player input, influencing gameplay through evolving relationships and personalized guidance. Through a controlled user study, we evaluate how AI-driven interactions impact player progression, perceived challenge, decision-making, and emotional connection, offering new insights in to the design of more responsive and meaningful narrative experiences.