The possibilities are endless, it's a great space to add something interesting. I like Sandybean's shelving idea. Maybe some really organic elements to go with your decor adding texture to the back wall with anything from a grasscloth to a coconut shell decorative panel.

Drywall it over.

I can't exactly tell from the pics, but it looks like there is one large niche in the center where you have your TV, and then there is the one niche (that I believe you're asking about) and the same size "niche" on the other side of the big niche which is really a doorway. So it's like they made the niche you're asking about to balance out that large wall, is that right? Regardless, I would dry wall over that niche .... it's too big and it doesn't make any sense.