My question is, how would employers view a character reference received from someone whose relationship with the candidate extends only as far as online interaction through gaming?
Not your problem. You've just been asked to write a reference. It's up to the recipient to decide it's usefulness.
Should I be frank about the nature of our relationship or should I skirt around it in more generic language?
The more specific and detailed, the better the reference. It is what it is, and there is not point in hiding the context or being "ashamed" of it. A good game admin needs plenty of skills that are useful in any other real world context as well: conflict resolution, complex management problems, day-to-day trade offs, etc.
Do I defend it and explain why I think my appraisal of his character is meaningful or do I just own it and pretend as if it's the most natural thing (which really, it is)?
Neither. Just assume it's a normal thing to do (which it is) and focus on the skills and specific examples: problem solving, management skills, conflict resolution, achievements, etc.