There definitely need to be more solid examples of character arcs in games. One that I am particularly sad to see a lack of (and, conversely, particularly pleased when it appears) is the "fall from grace" story. The interactive medium is a good fit for this: the player can be forced to start down a path they know is destructive, because their short term goals require it. The best example I've played is in WarCraft III, in which Arthas goes from noble prince to wretched wraith. What makes it work is that each step towards darkness that he takes makes sense for him at the time. He's not just suddenly deciding to become evil out of a lust for power; he's seizing power out of a desire to protect his people, and then being corrupted by it.