In essence: The people on the island are all part of a virtual reality. This could be from playing a game, as in eXistenZ, from being in suspended animation, as in Vanilla Sky or Philip K. Dick's novel Ubik, or due to some evil force consigning them there, as in The Matrix.

Flashbacks reveal the backstory of the characters not just to us, but to them as well. Characters with flashbacks are real people in the outside world. The rest of the residents of the Island are non-player characters, controlled by the same thing that is generating the virtual reality.

Support for this theory: In the season two finale, Kelvin tells Desmond that with the turn of the key, everything just goes away. When Desmond turns the key, the island stays right where it is, albeit with a sky that temporarily turns violet, which may be an homge to Vanilla Sky. Perhaps it was a way to leave Virtual Reality temporarily. Same with when Dave tries to convince Hurley to jump off the cliff, which could be another wink at Vanilla Sky.

Poking Holes: If this were a game, it is hard to understand the point of it. There is also something arbitrary about the way that Shannon's death was engineered. Perhaps her real-life persona bounced a check paying for her participation?