I think graphics do a great deal to create atmosphere and a believable world. And I'm not just talking about creating a photo-realistic world either.
That said, better graphics rarely make a game better. The one exception I can think of, are FPS games that focus on long range combat. Playing Sniper Elite on the PS2 is an exercise in frustration because of it's low resolution. You just can't see enemies at distance, and they can see you pretty well on the harder difficulties. So you are forced to constantly scan the horizon with your binoculars. This isn't an issue on the PC version because you can run the game at higher resolutions. Ditto with games like Ghost Recon and Armed Assault. Running those games at higher resolutions makes for a much more pleasing gaming experience.
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