In the Anuad, it is said that Anu tried to put the 12 Worlds of Creation together and created Nirn. The Ehlnofey and the Hist were said to be the only survivors of the 12 Worlds. As the 12 Worlds were part of the Godhead's Dream, Anu "stole" them and used them in his own Dream. It's part of the "borrowing" bit of the Amaranth. Anu dreamed of creatures he saw in his Dream of origin.
Yeah, here's how my friend on TESLore explained it:
Yep. They know they are inside another Dream, but they have knowledge of the current Dream and the old Dream as well.