I voted for the second option, but to be clear, I don't think you are a dumbfuck, it is just that number two is closest to what I think of these AI RPGs.
I've played around with these AI things, but while they can be interesting, they always get annoying and trite after a while. Also, of course, AI is not real intelligence, nor will it ever be.
But I think it could be actually useful as part of a CRPG. If rather than trying to make it the star, we made it just part of the game, and used a normal program to limit but also support what the AI can do. For instance, the AI could be used to create a conversation interface with the player. But rather than just spitting out text, it would also be expected to interact with the in-game characteristics. The reply should depend on the player stats, on the NPC, on the factions of both PC and NPC, on the reputation the PC has with them, etc. Replies should also trigger some in-game events. If you convince the cleric NPC to cast cure light wounds on you, then he should do just that, not just larp that he did. If you solved a quest while talking to him, then the quest status should be updated, etc.
This could work, and I think it is feasible if the AI is trained specifically for the game in question, noting it should not receive and output just test, but also game states and game commands. Also, while the conversation interface is the most obvious use for this, it could be used for other things. An AI could act as the "GM" of the game during combat, for instance, allowing the player to attempt any tricks he might think up. He might try to dodge an attack so he picks up some sand and throws it right in the enemy's face on his next move, for instance. And if the AI is well made, it might not allow it because there is no sand on the map in question.
So this isn't necessarily a dead end, I think, but I also think it would take a lot of effort to make something really interesting with it and I don't know if anyone actually has the motivation and the means to do that.