A still from James Cameron's forthcoming 'Avatar'

A few weeks ago, cameras caught 55-year-old writer/director James Cameron on the mixing stage at 20th Century Fox in Los Angeles as he stared at a clip from his upcoming futuristic thriller Avatar. He was unhappy with the look of mountain peaks on the horizon. He circled them with a red laser pointer and instructed his computer effects team at Weta Digital in New Zealand to shift them to the left. "Moving a mountain," he laughed, "is nothing."

That's the magic of digital 3D. It empowers directors as never before. There's nothing that can be imagined that can't be shown. Live action and fantasy all exist in the same shared dimension of virtual reality. No wonder Cameron feels like God.

It's 11 years since his last movie Titanic collected 11 Oscars and went on to become the highest grossing movie in cinema history – and also the most expensive, with a budget of $200m. Current production costs on Avatar are $310m and global marketing prior to its release on 18 December could cost a further $150m.

So what is it about Avatar that warrants such extravagant expenditure – not to mention Cameron's claim to be creating the future of cinema? What we know from a promo reel is that the film is set in the next century. Humans have stripped earth bare and are starting to do the same to Pandora, a moon in another star system. The air isn't fit to breathe so the hero Jake, played by Sam Worthington, lies in a coffin-like container while his consciousness is projected on to an avatar – a bluish nine-foot-tall surrogate simulating the characteristics of the local Na-vi population – through whom he explores the outmost areas of the moon where, of course, he falls in love vicariously with a Na'vi princess, eventually joining her in an insurrection against the human colonists.

Avatar is the latest in a wave of movies released in 2009 to take audiences into fantasy worlds that could only be realised visually by means of digital 3D imagery. All have reaped hefty box-office returns, beginning with DreamWorks' Monsters vs Aliens, which grossed $355m worldwide. Pixar's wildly acclaimed Up opened Cannes Film Festival and has so far earned $700m, while Disney's A Christmas Carol, shot by Robert Zemeckis with his own unique motion-capture technique pioneered in The Polar Express and Beowulf, is topping $100m. Advance bookings have already opened for Avatar and all the signs are that it will blitz global box offices.

So are we witnessing a breakthrough in the way movies are seen that is every bit as radical as the introduction of sound and colour? Do digital images mean the end of film, just as digital recording put an end to vinyl?

"Celluloid is dead, thank God," says Zemeckis. "It was a wonderful old system of recording images for over 100 years, but everything is digital now. Does anyone take photographs with film anymore? But I don't think all films will be in 3D, nor should they be."

Digital 3D will flourish best as a vehicle for big-event movies. More intimate subject matter will probably continue to rely on the greater visual ambivalence and subtlety of 2D, just as some animation stories continue to be hand-drawn rather than computer- generated, and not every movie is in colour. "It will be a judgment call for each director whether a story lends itself to 3D or would work better in flat 2D," says Zemeckis

Paradoxically, the extinction of film could mean the rebirth of cinema. The one positive sustaining Hollywood confidence in a year of studio upheaval and collapsing DVD sales has been the ability of digital 3D movies to deliver an immersive movie-going experience that can't be got from HDTV or home computer screens. Up to 7,000 digital 3D installations will be in cinemas by the end of this year, compared to a mere 84 in 2005. Forget about earlier versions of 3D, an optical device that goes back to The Power of Love in 1922. Digital technology has reinvented the eye-popping illusion so that it can be experienced with viewing lenses that fit as naturally as sunglasses while soon, if you're watching on TV, it will be possible to dispense with glasses altogether by placing a transparent lens on the screen.

"To me, digital 3D is much more beautiful and much more controlled because you're not bending light through a lens," says Zemeckis. "It liberates performance from technique. We basically make films in reverse. We start with the performance instead of what happens in traditional film-making where everyone has to hang around while you get ready a shot, light the set, and hours later actors are advised to step on their mark and hurry up, because we've got to go to lunch in five minutes.

"Everything is out of sequence. You shoot your wife before lunch and marry her in the afternoon. You stop for lights and cameras to be changed. You have to do the same bit over and over again, trying always to be spontaneous. What happens now is that we first bring the actors into the set and they act all day. They work like in theatre. They try things. You play the entire scene. It doesn't matter where you stand. There's no camera to play to. You play to each other. The relationships are absolutely real. You do it in your own time in sequence. When everyone is happy with what all the actors have done, they go home and I start putting my camera in and I create the movie. I can do anything I want."

Actor Jim Carrey agrees. "In some ways it's more pure than any other way of acting once you've gone through all the bizarre technological stuff, like being scanned and moulded and photographed and fitted into a tight Spandex body suit and a thing like a bicycle helmet with microphones which are not microphones but four little cameras pointed at your face."

Some people worry that technology is making everything less real, but Carrey holds with the theory that all film-making is artifice. "I've heard a lot of people say it's going to ruin cinema, but it's just another way to tell a story. Telling emotional stories has always been blending art and technology. A close-up is as much a special effect as a computer image. It's something that doesn't exist in reality. It's fake. Like sound 80 years ago, no one now asks did you record digitally or analog. In a couple of years, no one will wonder about digital 3D."

Avatar opens on 18 December