Stabilization of macromolecular folded states in solution by protective osmolytes has been traditionally explained on the basis of preferential osmolyte depletion from the macromolecule's first solvation shell. However recent theoretical and experimental studies suggest that protective osmolytes may directly interact with the macromolecule. An example is the stabilization of the collapsed globular state of poly(N-isopropylacrylamide) (PNiPAM) by urea in aqueous solution. Based on Molecular Dynamics simulations we have characterized the mechanism through which urea stabilizes the collapsed state of PNiPAM in water. Analysis and comparison of the different components of the excess chemical potentials of folded and unfolded PNiPAM chains in aqueous urea solutions indicates that enthalpic interactions play no role in stabilizing the collapsed state. We instead find that with increasing urea, solvation of the unfolded state is entropically penalized over solvation of the folded state, thereby shifting the folding equilibrium in favour of the folded state. The unfavourable entropy contribution to the excess chemical potential of unfolded PNiPAM chains results from two urea effects: (1) an increasing cost of cavity formation with increasing urea, (2) larger fluctuations in the energy component corresponding to PNiPAM-(co)solvent attractive interactions. These energy fluctuations are particularly relevant at low urea concentrations (<3 M) and result from attractive polymer-urea van der Waals interactions that drive the formation of "urea clouds" but bias the spatial distribution of urea and water molecules with a corresponding reduction of the entropy. We further find indications that urea increases the entropy of the globular state.