The absolutely most terrifying game I've ever played is Kuon for the PS2. I'm getting chills up my spine and on my head just thinking about this fucked up masterpiece. You can either play as one of two sisters. One's a melee character, aka you get a letter opener (yes, literal letter opener) to fight with. The other is a magic user. You get the world's worst fireball, or some other craptastic spell. You're investigating some Japanese manor where things aren't going so well for anyone. There are gaki, Gollum-esque demons that comprise the majority of your enemies at the start, gooey, pink masses of bones and organs, and, of course, the typical long-black-hair-over-face ghost girl. She lives in a trunk or something.

I was probably 14 or 15 when I played this game. Found it in the corner of an EB Games and picked it up immediately. I'd just run through a few Resident Evils and Silent Hills, but this was a whole new level of insanity. The atmosphere around this mansion just screams at you to either run away or become an arsonist, but neither of these are options, sadly. Pretty much everything will kick your ass. There's about no sound except for your tiny feet against the wooden floor. The whole game makes you feel helpless, at least up until the point where I quit and didn't look back.

The first boss of the game is this guy who has had his arms and legs broken. He crawls around on the ceiling and shit looking like a spider. Oh, his throat is also slit and his head is rotated around 180 degrees. After dying to him a couple times, I bailed on the game.

I think you're right on the atmosphere. It really does have to play into our primal fears. Darkness, isolation, unknown and/or unassailable predators. Less is more, as well. Less light, weapons, friends, information, sound, direction. Obviously, you can't just put a person in a pitch-black room and say "here you go, time to be scared!" The game has to be engaging enough to make the player want to continue forward. I think that the original Resident Evil did pretty well with that. Ammo was fairly limited, your team was separated and dying, this giant mansion had traps galore that you'd trigger accidentally, plus zombies and friends. The notes gave you glimpses into the backstory, just enough information for you to form a picture of what may have happened. There wasn't a big, glowing "go here" arrow, just what you could deduce from your surroundings.

The only way I can imagine a broad-daylight horror game working is if you, the character, knew something was wrong, but nobody else believed you. Could be that he's having a break with reality. I don't know how the whole story would work beyond that, though.