It is very hard to know this for sure because the only accounts we have of the episode come from Smith himself. He would have had an incentive to embellish the story to make himself look good.
However, there are many scholars who think that something happened that is similar to what Smith described, even if Smith himself did not really understand what was going on. Smith seemed to think he was really going to be executed. Scholars argue that Powhatan might simply have been trying to dramatize his power to impress Smith. Others argue that the episode was a ritual done to show that Smith was being adopted into the tribe.
We cannot know for sure, but scholars feel that it is likely that Smith did not make the thing up, even if perhaps he misunderstood what was happening.