The very creative, if very sad "Pennies From Heaven" (1981) has been undervalued for decades. Steve Martin and Bernadette Peters in the tale of a downtrodden Depression-era fella seeking solace in the far brighter worlds of the era's movie musicals.

The Fall, an absolutely beautiful masterpiece by Tarsem Singh
Favorite films of all time list
http://www.imdb.com/list/ls031708001

The Singing Detective
"I don't want a bloody avatar!" -paraphrased from BQQ's annoyances with IMDb's stupidity

There's a John Candy/Mariel Hemingway movie, too. Didn't Wil Farrell do one?

And then there's The Stunt Man from 1980.
"facts are stupid things" - Ronald Reagan

Anguish 1987
Funny Games 1997
The Holy Mountain 1973
This is not a signature!

Hellzapoppin'
blurs that line in a different way. Characters on screen end up having exchanges with the projectionist who is running the movie at the theater.

Lamberto Bava's horror movie Demons features a horror movie within the movie which seems to cause an outbreak of demonic possession in the theatre it's shown in.

I think David Lynch's "Mulholland Drive" might qualify as well.
There is definitely a film-within-a-film happening inside that movie, although how much of that film bleeds into the fantasy/reality blur is up for interpretation. There's too much going on in that movie to say for sure.

INLAND EMPIRE by David Lynch

Adaption

Stranger Than Fiction, Ruby Sparks are literary characters but there are blurred lines.
Feed me a stray cat.

"being john malkovich" is amazing
if anyone has a long list of these kinda movies please reply to my comment

This message has been deleted.

Last action hero

Yes blurring reality and make-belief is another topic. Then we could go talking about Truffaut, Godard, Lynch and so on. Even Play It Again, Sam. The French Lieutenant's Woman is another good film. In it reality and fiction get mixed up. Let alone Jean Rouch's sociological documentaries in the 1950's-60's..

Fun fact: In both TPRoC and Pleasantville, Jeff Daniels plays a sweet character from idyllic B&W screen fiction who turns to color with exposure to reality.

When it comes to blurring reality and make-believe, Inland Empire is the ultimate experience.
"facts are stupid things" - Ronald Reagan

I too opened this thread to recommend pleasantville
the movie is awesome, poignant and deep

Pleasantville is kind of the opposite (real world character entering a show), but probably relevant to whatever you're writing. It's also a really overlooked movie.
Videodrome touches on this sort of thing a bit, but is a pretty dark and relatively abstract movie by comparison. It's also not particularly great IMHO.

Hello,
Sherlock Jr. 1924 by Buster Keaton must be one of the first. However, the character walks on screen from reality rather than the other way round.