This one probably won't see the light of day, but i myself quite like it so here goes.
Basically, the idea is to implement the arcane simulation in a ridiculously detailed (read: dwarven) way.
Let there be two distinctive flavors of magic:
First, necromancy. Imagine there is the land of the dead, that is, an endless waste of gray ash where hungry spirits roam, separated from the living world (your fortress region) by the invisible wall. Initial 'thickness' of this wall depends on the region's good/evil alignment, and is further modified by the game play. When something gets killed, the wall gets a little thinner there. Where lots of things rot, the wall is eroded slowly but continuously. Where the wall gets thin enough, dead things can cross over to the living world and manifest themselves one way or the other.
For example, small thinnies would only result in the passing dwarf getting a morbid thought for no apparent reason. Bigger holes could lead to dwarvers getting possessed (in The Exorcist way, not the strange mood way), zombie infestations (dead things coming to life) and all other sorts of fun stuff.
Normally, only the largest massacres would trigger all this, but here comes the necromancer - some unpleasant bloke who specializes in breaching the wall to the other side - by sacrificing living things to the dead.
Benefits of this occupation are obvious: being the master of the dead lets you put a really good scare on one's enemies, allows you to animate and control the dead (or exorcise your possessed), maybe help the doctors a little bit by strengthening the link between the body and soul of your wounded... The tastiest (and the most dangerous) ritual would be the sacrifice of a dwarven child that allows the necromancer to cross over to the land of the dead and bring back something nice - maybe the soul of your recently deceased legendary armorsmith, or maybe something much much worse.
Drawbacks of all this hilarity are pretty obvious too, and heavy: your necromancers will be most likely shunned (or hunted down) by your citizens, not to mention the fact that the necromancer is basically an ambulatory hole into the world of the dead, resulting in all sorts of accidental break-ins, of which he would most likely be the first victim.
Necromancers could also possess the reverse necromancy abilities, that is, some way of fortifying the wall between the worlds, making your fortress a place of life and joy and goodness... but where's fun in that, right?
The second flavor of magic is elementalism. The basic idea behind it is roughly the same - there is an invisible world of pure elemental forces that is very malleable and can be shaped by the conscious mind. Unlike the world of the dead, which is just a plain, the elemental plane is a 3-dimensional box the exact size of your embarkment region. At the beginning of the game it is just a swirling chaos of primary elements with some pseudo-sentient elemental demons thrown in. As the game progresses though, your dwarves begin to shape it with their thoughts, the stronger their will, the more the effect. Where they pass, some sort of a corridor begins to shape at the elemental plane. The more they pass through the same place, the more distinct an impression they put on the elemental plane. Where they get happy thoughts, elemental plane gets happier and begins to spawn the nicer sorts of demons. Where they eat, the walls of the imaginary fortress become walls of flesh and hunger demons start to spawn and so on.
The result would be procedurally generated shadow of the soul of your fortress, where different kinds of elemental demons lurk.
As with necromancy, normally you won't see any of this, but then you train your mages who, by way of performing chants, rituals and other sorts of weird stuff, gain the ability to manipulate the elemental plane, that is, to summon and bind elemental demons of different kind to different ends. Say, lesser demons that have neither shape nor mind of their own can be used as elemental weapons (think fireball), while bigger demons can be used as thralls or bound to an item to enchant it. Conclaves of several skilled mages could open a stable gate to the elemental plane, allowing your military to pass through and capture something big, normally unsummonabe and highly unpleasant.
Naturally, this kind of power can't come without a price, so it doesn't. While more socially accepted than necromancers, elemental mages suffer from the prolonged exposure to the arcane. They get a little crazy, yeah. The more they practice their arts, the weaker their will, the lower their skill - the crazier.
Then there are two matters to consider: the fallout and the playing with fire aspect of it all. Magical fallout accumulates when the rituals are performed, or where enchanted items are stored. Maybe you get some weird-looking sparks. Maybe one of your unluckier dwarves suddenly gets an extra ear. Maybe a perfectly ordinary sword gets animated and chops the aforementioned ear off, along with something more vital. Maybe you build a network of arcane sigils that drain the magical fallout away from your more populated areas.
The playing with fire aspect is pretty self-explainatory, I think. Imagine your magedwarf going to the barracks where some heavy exercising is going on, summoning a rage demon and enchanting a war hammer with it. At first it looks like you got yourself a nice magical weapon, but then it appears that the demon was a little to strong for the mage, a little beyond his abilities to contain properly. So after a while the proud wielder of the enchanted hammer accidentally hammers his own head off, then the demon gets loose and roars through your fortress in search of his captor. Or - maybe your mage managed to bind a greater demon, a demon prince or whatever. At first the arrangement works perfectly (for you), but then your mage gets himself killed, or just knocked out, or drained after some other ritual. The seal that binds the demon prince breaks and OH HELLO FUN
Sooo that's the gist of it. What do you think?