Good points :)

I am actually working on such an AI system, believe it or not (As I am sure quite a few others are)! I don't doubt my algorithms, because I have already prototyped them and they work (at least well enough to create some interesting, if flawed gameplay), but I do doubt that I will ever get a game out that uses them effectively (making even a simple game is incredibly hard, and I have a bad habit of creating overly-complex stuff).

Your traditional AAA game does, as you mention, basically use finite state machines to determine enemy behavior (and incredibly simple ones, at that).

Why is a FSM bad?

Because someone MUST explicitly declare every combination of situation, and the paths between them.

How does my system work? It uses a combination of AI techniques that have been around a long time (just never used effectively in games).

1) Rules and queries (like prolog), with backwards chaining and propositional logic (basically a big, graph-based system). How might this work? Let's pose a few fake rules and a query. A) apples are red B) oranges are orange. C) apples and oranges are fruit D) red fruit is good...QUERY: are apples good? Using backwards chaining, this can easily be deduced.

2) Motivators and deterrents. Every NPC has their own set of motivations, as well as "bad" things they try to avoid. They attempt to maximize their output towards attaining their goals, prioritized with various points (i.e. get food: 1 point, stay alive: 10,000 points, etc)....the best outcome can be found with any traditional AI system (like a minmax tree, A*, or whatever is appropriate for the given case). This is not just about food or living, but can be emotional concepts like "seek happiness" or concepts that involve the physical world "find shelter"...

3) Basic AI for sensory and locomotion purposes (line of site, perception, planning, gathering knowledge, etc.)

4) Abstraction of communication -- not at the syntactical level, and not at the grammar level, but in its crudest terms ("higher level language")...I call it caveman-speak but there has to be a better phrase...i.e. "Me Hungry" or "Why You Steal" -- using sentence fragments, you can construct a variety of phrases without giving the computer a hard time interpreting it. On the surface, you can throw in the syntactical sugar to make it sound less crude to the user, but on the backend writing a full-blown english parser is not a wise idea.

5) There is more, but I won't type it out here...

In the simplest terms, think of it like an empty stage in a play. There is no director (Finite State Machine) but there are characters and props, and the characters have backstories/motivations/genetic makeup/birthrights that determine what they will do and how they will react to changes in their environment. When you have rules, motivators, and a knowledge base, you can let the AI run wild -- and producing new rules grows with linear complexity, rather than exponential (as with a FSM).

Alternatively, if you even played the Sims, imagine something like that, but with more comprehensive AI (NPCs seek to maximize their comfort levels (id) while acting within their restraints (ego/super ego)).

You can track my progress (or lack thereof) at gavanw.com...unfortunately I work a fulltime job in addition, so development is occasionally slow.