Brandon Watson defines it:
We human beings read, watch, and listen to a lot of fiction. We know that it is fiction. But we have emotional responses and attachments to the characters. So, according to Colin Radford, who first put it forward, this shows that there's something incoherent in our emotional responses: we feel for things we know don't exist.
J.L. Wall complicates this thought:
Fiction doesn’t present the unreal; it presents the possibly real, something balancing precariously between the real and the non. (This holds, it should be said, for fantasy, science fiction, and other “genres” as well as in realistic or literary fiction; they just go about it, as is the case in variation between individual works, in different ways.) We empathize with fictional beings not despite their unreality, but because of their possible reality.
Kyle Cupp is in related territory when discussing "narrative theory."