Defenition of Illusion: "something that deceives by producing a false or misleading impression of reality". "Psychology. a perception, as of visual stimuli (optical illusion), that represents what is perceived in a way different from the way it is in reality"
We can not disprove that the reality we percieve as the world we live in, is indeed a big fucking simulation kinda like in the Matrix. The whole "objective world" gouverned by laws and all that shit might simply not be what we percieve. In a dream, we see and feel a constructed physical reality. Its usually seen and felt with some inconsistency (If you're into lucid dreaming, try looking at your watch in your dream twice and see if the time matches 
), but it is still from what we know a "reality" simulated by our brains that feels real there and there.
Thus, it is possible that reality is an illusion.
End note: The question is pretty hard to answer 
This statement does not prove a thing. Reality can still be an illusion (see Debusseys earlier post), yet an illusion constructed upon rules which have consequences. Not to say that it IS an illusion, there is no way to REALLY know, but this exact quote does not prove a thing.
Your dream is not a reality and it's most certainly not physical. An object in a dream isn't real / palpable like the solid version of the same object that's sitting in front of you in reality (like a watch, to go by your own example). Going by what you say, a thought in your head be it in the form of a dream or a fantasy is the same as actually undergoing the equivalent physical experience. Are you saying your fantasizing about, say for instance, sleeping with a person is as real as the actual physical experience of the same?
You say we cannot disprove that 'the reality we percieve as the world we live in, is indeed a big fucking simulation kinda like in the Matrix'. But that is a meaningless argument. I cannot disprove that everything that has happened in my life is actually being controlled by a monkey that's going about it's business in some African jungle or something absurd like that. That doesn't mean I can therefore treat said absurd hypothesis with the same degree of seriousness or think it has as much validity as the fact that my own actions are responsible for what happens in my life (taking into account other factors such as environmental influence, the pre-existing conditions, context and so on). Because such possibilities are endless and basing an argument on such a premise would make arguing pointless or proving a point impossible.
There are absolute laws in reality that are universal - the fact that 2 objects attract each other with a force that is directly proportional to (the product of) their mass and indirectly proportional to the (square of the) distance between them i.e. the law of gravitational attraction is equally valid for all matter in any corner of the Universe, just like the fact that the sum of the squares of the 2 smaller sides of a right angled triangle is equal to the square of the hypotenuse, just like the fact that a human body needs food, water and air and optimal conditions to stay alive and so on.
