Another vote for Crysis.
For me it was the engine as a whole that made Crysis, not the graphics. Push slowly through the undergrowth, and branches bend back, leaves rustle. Hell, the bigger leaves actually show decals. You can see / hear bad guys making their way through the jungle using environmental signs. The first time I 'twitch shot' at a shaking bush only to have it shoot back - pure genius.
Getting chased by the wall hacking helicopter, I noticed that when it passed low to the ground, it kicked up a load of debris. "That's pretty cool," I said to myself as I dived full length into a shrubbery. Then I realise, as the chopper circles round my location, that the downdraft is actually making the foliage shake and move. One of the most brilliantly immersive moments I've had in gaming. The helicopter then proceeded to shoot down a 3 foot thick palm tree that I was hiding behind, the trunk of which actually fell on me, with nearly fatal consequences.
I later managed to be inside a small shack when a nade went off, prompting the collapse of one side of the building, the other half teetering on the edge. I survived the nade thanks to my suit, but was actually trapped under the debris, with a squad of NKA circling outside. Even strength mode couldn't extricate me, in the end I had to blow the shit out of the entire shack to get free, leaving myself dangerously weakened.
Plenty of other physics based awesomeness in Crysis as well.
An honourable mention for COD4 as well. In general the physiscs are pretty basic, but the bullet penetration thing is amazing, particularly for online play.
