Common interpretation is that the first "khwaab", in the line, implies "sleep" and second one "dream". Then the translation would be:
they are still asleep, who have woken up in a dream.
You are Right there are two interpretation.
People who, in a dream, see themselves as awakened, are still in a dream and asleep. When they consider that they have woken up, they are only in error. What kind of error is this? This error is not devoid of two aspects. The first aspect is that the sleeping individual has not had the experience of awakening. When he thinks that he's had this experience, he's only in error. In this way, to consider appearance and
shuhud to be the experience of divine wisdom is an error. But this error is not entirely without reality. The way the experience of waking in a dream is a shadow of the real experience, in the same way knowledge of appearances is a shadow of knowledge of the Truth.
The second aspect is that the person who is at that time absorbed in a dream, will sometime or other wake up. Just as nonexistence is a proof of existence, in the same way sleep/dream is a proof of wakefulness. Thus the error of thinking one has awakened in a dream, can be part of the earliest awakening that happens when the dawn is at hand. The waking of daybreak is that waking of the spirit when one was in the embrace of the Truth, and the present life is only a sleep of heedlessness. When the spirit saw the Truth in the form of appearance and shuhud , then it was in error when it thought it had returned to the state of its primordial wakefulness, when it had knowledge of all things.
