At 36, Fiona McFarlane says that she is “living the literary dream I’ve imagined since I was a child”.

Not only has her debut novel The Night Guest been shortlisted for Australia's most prestigious literary prize, this week she is also one of two writers in residence at Sydney writers’ festival, attending “everything and anything that appeals to me on the festival calendar” and blogging about them for the festival website.

The Sydneysider was in her pyjamas when she found she had been shortlisted for the Miles Franklin. “My publisher is away at the moment, so there was no phone call. I got an email from Penguin telling me. I was shocked and thrilled. It still feels surreal to see my name next to Tim Winton’s.”

A self-proclaimed “literary nomad”, she returned to live in Sydney only a year ago after more than a decade abroad, studying and undertaking writing residencies in North America and the UK.

During that time, her short stories earned her an MFA in creative writing and, until she submitted it as her thesis, The Night Guest was “my very personal and very private secret project – nobody knew about it but me and that was very deliberate on my part.”

By day, McFarlane attended writing seminars, as well as writing and workshopping her short stories. Evenings were devoted to working on The Night Guest in complete solitude, and she would write for hours, losing herself in the novel’s deeply emotional and unsettling narrative.

At the heart of The Night Guest is the rapscallion Ruth, a retired widow and former elocution teacher who lives alone on the New South Wales coast, whiling away the days “watching the sea” while struggling with the dementia that is slowly eroding not just her memories but the innate sense of certainty and security that made her feel safe.

“Both of my grandmothers actually had dementia and died, so Ruth’s story felt very close to home for me," McFarlane says, sadness colouring her voice. "I wanted to write about dementia in a way that wasn’t overly sentimental or stereotyped and explore it from the inside, as I imagined it might be. One of the hardest things about having two grandmothers with dementia was seeing that it really does affect people very differently and that carers can often be far from caring.”

McFarlane’s knowledge of dementia expertly informs her depiction of Ruth’s precarious and unpredictable sense of self, which begins to decline rapidly with the arrival of Frida, a government-appointed nurse. Ruth develops an unshakeable conviction that there is a tiger living in her house, waiting for the perfect moment to pounce. It is with this metaphor that McFarlane enters dark psychological territory, continually subverting the ways in which the reader perceives the narrative and its characters.

The Night Guest’s complex narrative poses myriad questions suffused by the novel’s sense of claustrophobia: Is Frida a cravenly opportunistic manipulator, preying on her elderly charge and stalking her as a tiger does its prey? Is there really a tiger? Are Frida and the tiger both imagined or are they one and the same?

McFarlane is thrilled that readers have “understood what I wanted to do, which was to stabilise and destabilise the narrative, and have the ambiguities of the story be embodied by Frida and the tiger. Ruth’s vulnerability makes her susceptible to mistreatment or manipulation by Frida, but dementia patients can be manipulative, too, in their own ways. I wanted everything thrown into disarray at a certain point, I wanted to make the reader feel confused, uncertain and lost, much as Ruth might feel.”

Though she’s currently writing short stories, McFarlane is also mulling a second novel. “I have done a lot of research for one that I shelved while writing The Night Guest. I may come back to it. I’m not sure yet.”

Asked about the festival’s 2014 theme –"it’s thinking season" – McFarlane laughs awkwardly before apologising profusely.

“I must, with some embarrassment, tell you that I haven’t given it much thought. I think just because I knew the festival was coming up and I would be participating. I know I am terribly nervous until I am preparing for an event.

“I’ve grown up attending the festival and I missed it living overseas, obviously, so returning as a published author feels significant – and a bit like a homecoming of sorts.”

• Editor's note: 9 June. Some of the quotations attributed directly to Fiona McFarlane in this blog post were compiled by the author from different parts of her phone interview with Fiona McFarlane. No ellipses, explanations in brackets or paraphrasing were used to indicate this to readers. This was inconsistent with Guardian editorial standards because change can alter – including unintentionally - the context or meaning of direct quotations. Since publication on 21 May, Fiona McFarlane has told us, and the Guardian accepts, that: her own grandmothers did not receive bad care when they suffered from dementia; dementia was not the cause of their deaths; and she did not intend when interviewed to convey those meanings.