Radiant A.I.
(NOTE that the facts given in this informal are somewhat exaggerated and out of date.)

Oblivion boasts a new artificial intelligence system, fully developed in house by Bethesda, codenamed 'Radiant AI'. It aims to counter what was believed to be one of the major flaws of the previous installment (The Elder Scrolls III: Morrowind): the lack of 'life' of the NPCs in the game. Radiant AI gives every NPC a set of 'needs' (such as hunger) that they will need to fulfill, thus creating a more lifelike world.

Radiant AI works by giving NPCs a list of goals. Nothing else is scripted. They must decide how to achieve these goals by themselves based on their individual statistics. A hungry NPC might compare his current gold against his moral values to decide whether he will walk to a store and purchase food, or just steal it; a skilled archer can choose to hunt his own deer.

This has required massive testing, but has even greater long-term flexibility for future NPC AI as well as testing with PAC AI for further developments.

The following are examples of unexpected behavior discovered during early testing:

One character was given a rake and the goal "rake leaves"; another was given a broom and the goal "sweep paths," and this worked smoothly. Then they swapped the items, so that the raker was given a broom and the sweeper was given the rake. In the end, one of them killed the other so he could get the proper item.
Another test had an on-duty NPC guard become hungry. The guard went into the forest to hunt for food. The other guards also left to arrest the truant guard, leaving the town unprotected. The villager NPCs then looted all of the shops, due to the lack of law enforcement.
In another test a minotaur was given a task of protecting a unicorn. However, the minotaur repeatedly tried to kill the unicorn because he was set to be an aggressive creature.
In one Dark Brotherhood quest, the player can meet up with a shady merchant who sells skooma, an in-game drug. During testing, the NPC would be dead when the player got to him. The reason was that NPCs from the local skooma den were trying to get their fix, didn't have any money, and so were killing the merchant to get it.
While testing to confirm that the physics models for a magical item known as the "Skull of Corruption," which creates an evil copy of the character/monster it is used on, were working properly, a tester dropped the item on the ground. An NPC immediately picked it up and used it on the player character, creating a copy of him that proceeded to kill every NPC in sight.
Bethesda has been hard at work to fix these issues, balancing an NPC's needs against his penchant for destruction so that the game world still functions in a usable fashion. In-game there are over unique 1,000 NPCs, not including monsters and randomly spawned bandits.