So then evil isn't an illusion, but an instrument of God to better the universe?
If you define evil as suffering, than yes.
If you define it as the ability to choose to move in the opposite direction of G-d, then still yes. Just that it refers to the subjective placement of the individual (along the continuum that is the natural progression of the Divine Perception congealing into the physical) towards the direction opposite G-d.
I'm not sure if that's clear, so I'll give an example.
If two people are climbing a ladder, what is up for the lower person, is down for the upper person. Up and down are both subjective concepts with relation to the people. At the same time, the ladder itself (when its standing anyway) has one side that is inherently up and one side that is inherently down of itself at every individual point in the ladder and in the ladder in general.
Your long version was a bit confusing, so I will try and summarize what you've said to understand it. Let me know if I'm right or wrong: God is everything and his perspective is in everything. The perception of his perspective contradicts existence and free will. Without perception of God we have existence. God contracts himself, leaving a void, within which there is creation. If you are within the void and do not perceive God, then you cannot have a relationship to God. Thus you are in the physical in the void, and farther from God. If you are in the spiritual, you are closer to God. Is this right?
If so, what is the void? If God is everything should the physical, the void, creation and everything all be a part of Him. Shouldn't we be as close to him in the physical as we are in the spiritual? Unless the void exists outside of God, which means that there is something outside of God. Which would mean that evil exists independent of God.
I use the word void because its devoid of the perception of G-d, not devoid of G-d Himself. We remain intimately within G-d. What we lack in the void, is the overpowering Perception of G-d that negates everything. Because G-d is inherent in everything, if the Perception of Him was present, there would be room to perceive anything else. So with the Perception removed, there is some small degree of room for existence to be perceived separately from G-d, while still ultimately remaining intimately connected to G-d.
When we speak about spiritual or physical, we actually mean more or less able to perceive the Perception of G-d.
Okay so if God constrains himself to test us, but knows the outcome anyways, what is the point? He knows what we're going to do, and he has created the conditions to do it so his constraint is kind of useless.
That's where the concept of "bread of embarrassment" comes into play. It creates a concept that makes it possible for us to derive more enjoyment of the end result as reward, than had we been handed it as charity. Meaning, the ultimate purpose of the testing is to benefit us, not because G-d needs it.