The fluff for the power indicates it is a magical compulsion. The wizard would have no problems if he truly believed the invisible paladin was in his AoE. An individual melee or ranged attack cannot know for sure that the paladin is in this or that square. Once he's invisible, the opponent just isn't sure. Thus they'd either have to take the damage, or wait out their turn. If something could truly believe that a chair IS the paladin (not something I'd ever do), then yes, the loony bastard wouldn't take the damage. But then he has other problems already, so...