Some thoughts after reading The Psychology Behind Games by Anders Hejdenberg.
Should a game adjust it's difficulty level based on the players observed ability in the game? Possibly, but it's an artificial device. Response to changes in the players ability should probably err on the cautious side when making the game easy and on the converse side when making the game harder. It's important to have player profiles, too. Visual feedback of the current setting and a manual override would be nice, too. Some people don't want things to be too easy and for the game to "surrender", but other people would use such a mechanism to cheat, or just plain want to go through the game quickly.
Feedback and control are the watchwords, as ever.