It seems that because the player collision is a capsule, if i snap the player to the side of a very steep hill using the Y co-ordinate of the terrain directly underneath (or above) him, the capsule will still overlap the side of the slope and the player will fall through.

Does this sound accurate? I'd be interested in knowing exactly what part of the character can overlap without falling through.

Will you always know where a given modification will occur? Maybe as part of the terrain modifying script, you can find all the players in the affected reigon and move them in the same step. As far as I know, capsule colliders are fairly resilient when it comes to slight overlap- if they are less than half of their total width through another collider they will get forcibly ejected in the next phyisics step

So, no, I don't think it'd be a problem. Have you tried giving the players affected a small upward force to bump them over the modified terrain? It'd make a bit of sense, as well- seeing as a big hill just appeared under their feet!

That's exactly what i'm currently doing - calculating a radius around every modification, and bumping every player in the radius up. In fact what I'm doing is checking the height of the terrain at the player position, after the modification, then bumping the player to that position plus a little bit more for safety.

However, that safety number is a little higher than I'd like (0.2m), anything lower and occasionally players fall through the world..

Maybe I misunderstand what GetInterpolatedHeight returns, do you need to scale it depending on the height resolution?

Here's the code I'm using

var playerTerrainPosX = (playerFeet.position.x - terrain2.transform.position.x) / terrain2.terrainData.size.x; // assumes terrain is at origin 0,0
var playerTerrainPosZ = (playerFeet.position.z - terrain2.transform.position.z) / terrain2.terrainData.size.z; // assumes terrain is at origin 0,0

var terrainHeight = terrain2.terrainData.GetInterpolatedHeight(playerTerrainPosX , playerTerrainPosZ) + 1.05;
if (playerFeet.position.y < (terrainHeight - 0.01) )
{
    Debug.Log("Player is below terrain, bumping up. Player was at height : " + playerFeet.position.y + ". Terrain was at height: "+terrainHeight+". Bumping to: "+ (terrainHeight + 0.2));
    playerFeet.position.y = terrainHeight + 0.2; 
}

Do your characters use rigidbodies? If they do, instead of just manually assigning the bump, do that and then use AddForce to make the player jump in the air a bit. This way it makes sure the player is entirely out of the terrain, and it lets normal collision take over when the player lands.