That's a poor definition which you won't find repeated in any other reference (really, take a look). The entirety of the meaning of the idiom concerns the misperception of ones opponents.

That's incorrect. A number of other sources say that it also means exactly what I mean: "to pursue an unrealistic, impractical, or impossible goal". E.g.:

http://www.word-detective.com/2009/03/10/tilting-at-windmill...

A quick peek at Google News also shows plenty of people using it that way:

E.g.:

http://articles.mcall.com/2012-03-08/news/mc-pat-toomey-jobs... http://jurist.org/forum/2012/02/brian-landsberg-affirmative-... http://www.idahoreporter.com/2012/barbieri-wont-run-anti-tsa...

isn't it from Don Quixote?

Yes, it is.