This is a common feature of roguelike games, Angband, NetHack, and the like (not coincidentally, Andrew is the developer of an Angband variant, UnAngband). You maybe be more familiar with the permadeath game-style in something like Diablo 2, Hardcore mode. To be clear to those who aren't familiar with playing a permadeath game, even going back to an old savegame is not allowed, or at the least, is considered cheating.
In an RPG, there are 2 key requirements for a game to successfully implement the permadeath feature. The first is some degree of randomized, emergent gameplay. That is, even if you are playing the start of the game for the tenth (or hundredth) time, the game is different, with randomized levels, different monster configurations, and so forth. If you're going to be replaying the same part of the game over and over, there probably needs to be some need new and novel aspect each time.
The other requirement is that, from game to game, a player's (not character's) skill increases; he gets more proficient, learns more, and becomes more adept at the game. This allows him to progress farther in the game, and he gets satisfaction that he is improving, with visceral proof in his in-game achievements.
A game that meets these requirements, and implements the permadeath feature, can provide a level of satisfaction and challenge that is unmatched in other games. When I finished, say, Morrowind, I felt happy and satisfied, but when I won Angband - man, I really felt like I had accomplished something.
That said, permadeath games can be extremely frustrating. I would even say that a lengthy permadeath game like Angband has a very limited audience. Diablo 2 works around this issue by making Hardcore mode optional; I would guess that almost all Hardcore players had played the game through on an easier mode first. And, for a story-driven game like an Ultima or a Bioware game, permadeath would be completely inappropriate; who wants to read the first chapter of a book 100 times?
So, the common approach in story-driven games is, at least least, to allow re-load of a game from an old save-file in the event that your character dies. Some games like some of the Ultimas, or Planescape Torment, simply bring your character back to life, and you continue to play; in the case of Planescape Torment, with no penalty at all. With "Untitled SENG Game" (and the SENG engine in general), I take this approach as well; if you die, the engine simply restores your character at a nearby "safe point" and you proceed. This is how most players play anyways; why make the futz around with game saves and restores to achieve this?
How, in this "death means nothing" design, can we maintain the twin senses of achievement when the player attains something, or failure when his character dies? I've put some thought into both of these.
First, in the case of failure, my preferred design is to leave the sense of failure up to the player. That is, there is no in-game penalty for dying, no quest that now can't be completed, nothing. How can I justify this? Well, personally, when I'm playing a long, engrossing role-playing game, and my character dies, I fel bad. I'm invested in my character, I want him to succeed; even in games where I can simply restore an old game, I still hate to die. So, my design is relying on the immersion of the game and its characters to provide a disincentive to death; I can only say that this is personally effective for myself, and can hope that this applies to other players as well.
Secondly, for the sense of challenge, well, I'm afraid I may have lied a little bit. I claimed that there was no penalty for death. While strictly true, there is something of an in-game disincentive; let me explain. A SENG game subdivides the overall challenges of the game into sub-achievements, which I call quests. Encounters in the game are associated with quests, in such a way that if the quest is complete, the encounter is removed from the game. However, if the quest is incomplete, the player resting (to restore characters hit points, etc), or dying, will also restore any encounters associated with that quest, even if the encounter was previously defeated.
Let me give an example. Say "Slay the Goblin King" is a quest. Then, the level "Goblin Warrens" is packed with goblins (subgrouped into encounters), with the Goblin King himself somewhere near the back. If the player works his way into the warrens, killing off half of the goblins, but then retreats to rest, or dies, the goblins are restored to the level. Only if the player can penetrate all the way and kill the King do the goblins stay dead.
In this system, there is are distinct, challenging achievements. Completing a properly levelled quest should be a big deal to the player. Failure means that he has to replay the quest. Note that good level design is imperative to ensure that this system does not lead to frustration; while it is OK for a player to occasionally fail and have to replay a quest, this should not happen too often. The player should be led towards the right quests, steered away from too-difficult quests, and long quests should be broken into sub-quests to avoid long replay sessions.
As an RPG designer, you need to think hard about the death problem. Whether you go for a permadeath approach, a no-penalty approach, or somewhere in between, will heavily influence the player experience. With SENG, I'm trying to provide a more seamless, player-friendly approach than games that have gone before; with your game, you may want to take a different tack.