When it comes to psychological horror in games, the first example that springs to my mind is the Shalebridge Cradle level of Thief: Deadly Shadows (TDS).
The Shalebridge Cradle is just one mission of the entire TDS, which isn’t, in general, a horror game. For me, however, it stands out as the best mission in the game because of the incredible atmosphere and feeling of dread it arouses in me.
The first part of the Cradle (I’m ignoring the grounds of the building) comes when you enter the Cradle itself. You eventually learn that the entire first part is devoid of enemies. There is nothing there that will attack or even glare meaningfully at you. Even with that knowledge, the atmosphere is tense, keeping you on a knife edge, waiting for that unknown something to emerge …
If there are no enemies, then why is it so frightening? It’s not just the state of the building, the decay, but also the aural environment. You hear voices, you hear footsteps, and somehow you know someone is just around the corner … or just behind you. They’ve tuned the visual and aural environments to perfection and even knowing that there is nothing there, part of your brain doesn’t believe that. It’s tricked into believing that something is there, no matter what the evidence.
The second part of the Cradle is just as horrifying and atmospheric, but for slightly different reasons. We get our first look at the denizens of the Cradle: undead, shambling things that were probably once human, but now seem kept alive by either magic, or some technological horror. Having seen them, however, the horror is wound down a little. We can see our enemy, and they’re no longer the unknown.
Parts of that section of the Cradle, notably the old psychiatric cells, still evoke that terror of what might be there. You hear the screams, the sobs, the incoherent rambling, even when there are no enemies close.
The third section of the Cradle is really the first two areas again. You’re now no longer technically in the Cradle as it is today, but in the memory of the Cradle as it once was. The decaying building is now ‘new’ again, and people populate its halls.
Except this time they’re memories of people; people shaped silhouettes, that can turn to face you … Somehow these are more terrifying and eerie than the shambling horrors from before. However it still doesn’t match the feeling of that first, uninhabited section.
I really doubt you could string the atmosphere of that first section across the entire level, and certainly not across the entire game. However, as a stand-alone section it shows how well psychological horror can work in a game. Thereafter using it sparingly it still ratchets up the tension without it becoming ‘ho-hum’.
Having said that, I’d really love to see more games try this, even if it’s only for part of the game.