I felt compelled to respond because the question is so often framed in all the wrong ways. There are some widely held assumptions, such that 1. Nobody cares about story in the game industry or 2. There's not enough writing talent in the industry, assumptions that clearly false if you spend a lot of time milling around industry shows or talking with top-tier developers.
Ben Kuchera from Ars Technica actually goes so far as to say that game writers "need to get out more, need to read more than science fiction, and need to watch movies that don't involve guns." Most developers I know -- some of the most well-read people on the planet, many of whom have PhD's in everything from history to classical mythology to astrophysics -- would find that remark completely insulting.
Still, it's hard to argue with what's on the store shelves. Not many games feature story as an integral part of the experience. When they do, the results often fall short of high critical standards -- Command & Conquer 3, for example, intentionally relishes its own cheeziness.
So what's really going on? Why is story a square peg and gameplay a round hole? I'd like to try to frame the discussion in a new way, ask some different questions, and see what solutions we can come up with.

Games like Deus Ex (Released in 2000) made some leaps forward,
attempting to balance both story and interaction.
Entertainment vs. Activity
First, let's classify games in the right space. A lot of commentators make the assumption that writing in games will get better if game developers bring in the 'professional writers' from other industries -- novelists, TV writers, screenwriters, etc. I agree with half of that assumption. Certainly, good storytelling techniques apply across most mediums. This interview I did with screenwriter David Freeman in 2005 talks about the pros and cons of game developers working with screenwriters.
But the unspoken assumption there is that games and passive entertainment share the same basic DNA, which I disagree with. Movies or books are 99% passive -- they are entertainment. But games are an activity. Games are something you do.
This is important when it comes to story. Passive entertainment is about the story. The story is everything! The story is why you watch a movie or read a book or tune into a TV show. Bad story? Bad experience. No amount of presentation or special effects can change that.
Games are judged by a different standard. They're an activity. Is the activity fun? Is it gripping? Does it challenge your intellect, reflexes, puzzle-solving, memory, social skills, etc? Activities can either be fun or boring. No amount of presentation or cool graphics or new technology can change that. Games are judged by the quality of the activity they provide.
Nobody ever wants to come out and say it, but I'll step into the beartrap: Story isn't the central element of a game, and by definition it never will be. A game without a story, as we've seen in hundreds of titles, can still be a great game. Story can be a part of a game -- it can inform or give context to the activity -- but it's not central.
Most players won't slug their way through a bad game just to see how the story turns out. There are occasional exceptions -- games that I've pounded through with cheat codes just to see 'how it ends' -- but at the end of the day you don't say to yourself "That was a great game."
No, games are an activity, and the richness of the activity will always supersede story.
The Value of a Good Story
Hold on! Let me get in a couple more paragraphs before you begin reaming my inbox. I'm not saying that story isn't valuable. Games are my job, so it's telling then that when I'm not 'working' (read: playing World of Warcraft), I'm reading books or writing my own.
We're all people, and people love good stories. Games, as an activity, can tap into certain reflexive emotions, like fear, frustration, or triumph. But stories open our hearts to the whole of the human experience: love, justice, compassion, belief... all that heavy stuff. If games can find a way to tap into that, then we've stumbled on The Perfect Entertainment.
Certainly, when a compelling activity meshes with a moving story, the fireworks go off. A half dozen games keep cropping up in critical discussion whenever the topic comes around. Final Fantasy VII, for example. Ico. Deus Ex, assuming you took the time to really think about the statements the game was trying to make about the role of government in the age of technology.
So story definitely has a place in gaming.
But that brings up the central issue: stories are fixed constructions, a single-thread of narrative calculated to build up to a climax and make a statement. Games are interactive, requiring freedom of choice by definition. So how do you do both at the same time? That's what game developers wrestle with.
Various Means for Telling Stories in Games
It's not like this is a new problem. Developers have been wrestling with this for decades. There's a GDC panel about games and storytelling every year, usually featuring some of the brightest minds in the industry. Game guru Chris Crawford struggled with the problem for years, and finally gave up on the traditional games industry (famously declaring the games industry D.E.A.D.) and moved to solve the problem with his own wildly experimental software.
But in the meantime, a few different approaches have come to the forefront. I'll name 'em off as I see them. In all of my charts in the following pages, the solid blocks represent gameplay -- the freedom of the player to interact in a world -- and the squiggly lines represent story narrative. On to the techniques!
NEXT PAGE: Various Means of Telling Stories Interactively...
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Aion Game Client v1.5
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