This is part of my Dynamic World series of ideas. The basic concept is that NPC 'fluff' dialogue will change and respond to events that happen in the world. This is done via the Rumor Mill. Rumors are created by the system when significant events occur, be they player actions, NPC actions or Gm triggered events. These rumors are seeded amongst appropriate, nearby NPCs and then have a chance to propagate throughout the land.
Some NPCs, of course, will be more likely to keep up with all the rumors (Innkeepers for example, or that beggar who does nothing but wander the streets all day) while others will ignore them completely.
Each NPC would have a limit to the number of rumors they would know at any time, and they would also have a prevalance towards cetain types of rumors (IE, merchants would be more interested in bandit activity and finds of new resources whereas farmers would be concerned with wolves attacking their animals or bugs ravaging their crops). Rumors would generally be spread along trade routes, be it via boat, pack mule or foot. And there would also be a chance that rumors don't spread to the next town for whatever reason.
It would also be neat to add a "Telephone Game" feature to the Rumor Mill, allowing for some rumors to change as they pass from mouth to mouth. The mechanics of this would be difficult and problematic to implement though.
Rumors themselves would be flagged for importance on a local, regional and world level. If Bob the Knight clears out a den of wolves near the town, that would be of interest locally, but probably not much beyond that. However, if Bob slew the great Fire Dragon who had been terrorizing the mountain villages for generations, that would be an event worthy of worldwide renown. Rumors would also have a persistence rating. Driving off the wolves would only be noteworthy for a short amount of time. But the victory over the dragon would be spoken of for many years to come!
Rumors would also have the added effect of making famous/infamous players known to NPCs, even if they've never set eyes on each other. If everyone knows that you were the one who slew the dragon, then you'll receive praise and adulation as you travel. On the flip side, if you're infamous for the butchering of small farming villages, then you might find yourself persona non grata in the entire region, forcing you to travel halfway around the world to find a city where they don't know your name and reputation.
This would also allow players some insight into local events while they are travelling. Talk to the innkeeper or other gabby NPCs to get info about whats going on.
NPCs would also have rumors about each other. Everyone in the village would know that the local blacksmith was horribly wounded recently and is unable to perform any blacksmithing duties. Smart players might see this as an opportunity to ply their own blacksmith skill to earn some extra cash, and possibly the appreciation of the local citizens, which in turn might foment a new rumor concerning the new blacksmith that recently arrived in town! Or there might be rumors about a local mage recently acquiring a Book of Demonic Summoning which in turn triggers dynamic quests from locals who want the book destroyed, or wish to acquire it for their own shady purposes!
This also ties in with another of my required, MMO Core Concepts, Every Action has Consequences. But rather than having some mystical, overarching reputation that is automatically and instantly known worldwide, NPCs would spread the words of your deeds in a semi-fluid manner, furthering the goal of a dynamic, changing world that responds to player actions in a meaningful manner.