Sky Siege ($3, available now) uses the iPhone 3GS' compass and accelerometers to turn the iPhone into a window rather than just a screen, resulting in startlingly immersive gameplay. Don't know what that means? Just watch this remarkable clip. [iTunes]
Looks very awesome, but at the same time it seems like it would lose its appeal rather quickly, given the practicality issues. On top of the obvious issues (looking like a fool in public or even at home, etc.), I gotta think having the camera on like this will cook through battery in no time.
IMO the whole Augmented Reality thing is overblown and will become a niche feature in the next 6 months or so. I was excited when Yelp added it, but after the initial experimentation I haven't used it in months.