Illusory or erroneous knowledge is based on non-fact or the non-real [Iyengar]
I think the second interpretation explains this sutra the clearest, that misperception causes false knowledge or illusion. Take for example the act of looking at a pencil in a glass of water – it appears bent at the point where the pencil meets the top of the water line. Even if we know that pencil is not bent, that it is in fact a visual illusion, we still perceive the illusion. This is the incorrect perception or knowledge that Patanjali is talking about.
However, he could also be talking about illusions caused by the way we think about the world. We might think that we really get on our neighbour’s nerves, that they really don’t like us. Every time we see the neighbour, and she doesn’t smile at us, it confirms our (erroneous) belief that she doesn’t really like us. However, that belief may be false, the neighbour may actually love us, or feel totally indifferent towards us, and might just be having a bad day. Our belief about the neighbour colours how we interpret her facial expression. This is also a false perception. We cannot always trust our own thoughts and perceptions.