The Village is an alternate universe where they sent #6 (James Caviezel) because he was tired of spying on people for the corporation and quit.
#2's son kills his mom and kills himself.
The redheaded female doctor makes a deal with #2 (Ian McKellen) to keep #6 alive by agreeing to be his wife but always being drugged up like #2's wife was. #2 dies.
#6 becomes the new ruler of the Village and the doc is the new dreamer who keeps the holes from showing up in the village by always being in a drugged state.
Jonathon adds these important points:
There are four points to The Prisoner that have need to be explained; What is the company and village, who are the watchers, why do people in village dream, what happens to those who die.
The village is really just a fantasy world created by someone who is put into a drug indused sleep like state. This person is sleeping in the real and dream world. #2's counterpart in the real world runs the company. His wife was a biochemist and she discovered that there really is a subconscious to every person, and not just one but many levels of subconscious. And that these subconscious could be captured and sent to live in another subconscious dream.
What the company has been doing is taking people who have mental disorders and kidnapping their subconscious. Their subconscious is than sent to the village were it can get treatment for the mental disorder. Even though it is the subconscious that is getting the treatment, their counterpart in the real world benefits and is able to slowing recover from their disorder.
There are really three different kinds of watchers that work for the company. Ones that watch people and diagnosis those that have hidden problems and report that to the next floor up. #6 in the real world was the companies best at finding people that had hidden mental stress. The next set of watchers are those that watch people that have a subconscious in the village, they watch them to look for signs of improvement and setbacks. The third type of watchers are people that work for the company that have their subconscious sent to the village to watch those that are in the village for treatment.
People in the village that are dreamers are people who are starting to worsen in the real world. The subconscious is starting to return to their real life counterpart. What they see as dreams of another world are actually them going back to the real world. This is way dreamers are watched. So the company can find the people that may be in danger in the real world of reverting back to a mental disorder state if they loose their village counterpart.
When People die in the village they don't die in real life, it is the main way for a person in the real world to regain their subconscious. #2's son in the village however really did die in the village as he was only part of his mothers dream and not real.