okay. so I want to know how to make game 3D models and design levels. where to start? A free open source solution would be best.
Additionally, how do you create those realistic looking textures on 3D objects?
Is Blender a good choice?
Is there an outsource or market place for purchasing game assets?
If you just want to rush ahead and get your hands dirty by coding, there's the NeHe tutorial series that is quite well written and is very practical.
For a pre-built 3D engine, check out Crystal Space (I'm not how up-to-date it is).
However, if you ask me, it makes sense to get some understandig of 3D geometry and computer graphics theory (affine transformations, etc.) before you start coding as it will make things a lot easier later down the road. One great resource of that is the MIT 6.837 Computer Graphics Course (it's available online for free).
For the creative part (how to design levels, how to draw textures) I'm afraid I can't help you and quite possibly this is not the right site to ask/answer anyway.
First, unfortunately this is a wrong site for these sort of questions since you're not (apparently, correct me if I'm wrong) asking about programming your own 3D engine/whatnot but how to create 3D content which is an artistic feat. I'd suggest you head over to CGTalk and VFXTalk, they both have their own subforums for people who are interested of programming 3D stuff.
However, since I used to be a 3D hobbyist (Lightwave 3D, woo!) I do feel that I should answer your questions so here goes:
First, only reasonable open source solution to look into is Blender 3D as you thought. However it's quite horrible in usability and does nothing well, it's a Jack of all trades and master of none, not to mention it's abysmal usability. From the code POV it might be interesting to look into though since it does all the basic and some rather advanced things related to 3D programming as a whole.
Second, materials have been the hot issue in CG for years now. There's several general purpose algorithms for achieving a certain look, for example Wikipedia has a list of the most common ones and that's just the beginning. As an example of the more advanced stuff, screen-space ambient occlusion is a method used in modern games such as Crysis to fake global illumination which traditionally has been achieved through clever use of virtual lights or raytracing/raymarching algorithms possibly using some form of Monte Carlo method such as Metropolis light transport. For a lot more research on this and other related subjects, check out SIGGRAPH's home page.
Also note that the previous chapter I just wrote is mostly about lighting the models instead of creating textures etc. Realism has three parts, lighting, shading and animation (or accentuation for stills).
Lastly, there's several web sites which do sell 3D models created by others, I've never personally used them and I've long since forgotten most of the URL:s but there's one I still remember, Turbosquid. ANd yes, there is a market for these, for example architects use a lot of stock models for populating their 3D mock-up pictures of unbuilt houses to give them a sense of scale and in general make them look more lively.
I agree that this is not strictly the place to ask this question. You may look at the many fine articles, resources, and tutorials on GameDev.net. I strongly disagree with Esko on the point of Blender: the software has significantly improved in recent versions and is undergoing a complete interface overhaul in the next release (2.50), currently available in alpha. The interface may be cluttered at present, but I find that Blender's interface design has a tendency to enhance rather than detract from my 3D production workflow. Even working on in-depth New Media projects, Blender has more than proven to me its worth and efficiency. It also has a quality 3D game engine with both drag-and-drop logic and Python automation.