The nature of the Confession dial wasn't established so it is open to speculation but personally I see the events as totally real, as in they actually happened in a physical universe. Remember that the Time Lords are adept with higher (or other) Dimensional technology. You can see the confession dial as being a pocket dimension pretty much just like the interior of a TARDIS.
Also, the castle and the Shade were both clearly shown to be mechanical contrivances. They weren't illusory; they were physically engineered. They worked, literally, by clockwork, not by any kind of sleight of hand or apparent 'magic' or dream logic.
This is in keeping with how Moffat has envisioned the Time Lords so far: as a race of incredibly advanced engineers, who have learned to incorporate black holes, higher dimensions and time travel into their engineering. I personally love this interpretation.
To me, yes, it all happened, it was physically real, but happening in some other dimension, a TARDIS-like space (after all, if one thinks about it, the TARDIS is outside of our conventional space-time too. One could spend a million years inside it whilst being immune to the passing of a million years outside, as it is not part of the same space-time continuum) contained within the Confession dial.
The resetting of the rooms and so on would work in exactly the same way the TARDIS deletes or adds rooms, changes the look of the console room etc.