The word 'but' is equivalent to 'just' or 'only'. The phrase means "Life is just a dream". You will come across this adverbial meaning of 'but' quite often in older and more formal contexts. For example, if you see a film set in the 19th century, you might hear the phrase "He is but a child", meaning "He is just a child" (not an adult). Either of your interpretations of 'dream' would be correct.

Maybe this'll help you? It has a couple of translations: https://glosbe.com/en/ru/life%20is%20but%20a%20dream And according to my short search you can feel free to interpret "dream" in any way you see fit (or find in a dictionary). There is no limit of one particular meaning.