Five years have passed since Freddy Krueger was seemingly defeated and the Walsh’s have moved into the Thompson’s former home. Their teenaged son, Jesse, has a nightmare about being stranded on a school bus with two girls and being stalked by a violent killer. He wakes up in terror and attributes the dream to the unusual heat in the room. Jesse goes to school with his friend Lisa, whom he is interested in romantically, but is too shy to flirt with her. After getting into a fight with a boy named Grady during gym class, Coach Schneider makes them stay after class and they eventually become friends. Lisa comes to visit Jesse after school and they discover a diary from Nancy Thompson detailing her nightmares which are strikingly similar to Jesse’s. Small fires happen around the house, which culminates in the spontaneous combustion of their pet birds. Jesse’s father accuses him of sabotage. Lisa takes Jesse to an abandoned factory where Fred Krueger worked, but they find nothing there.
The following night, Jesse has a nightmare where he encounters Freddy Krueger, who tells Jesse to kill for him. The dreams grow more intense and Jesse attempts different measures to keep himself awake, none of which stop him from approaching his sleeping sister with a clawed glove. The experiences terrify him as he finds himself wandering the streets at night. Coming across an S&M club, Jesse is caught by Schneider when ordering a drink and is made to run laps at school as punishment. After sending Jesse to the showers, Schneider is attacked by sporting equipment that comes to life in his office. He is then bound by a jump rope and dragged to the showers, where he is stripped. Jesse vanishes into the steam and Freddy emerges, killing Schneider by slashing his back. Jesse’s is horrified to see the glove on his hand. He is escorted home by police after being found wandering the streets naked and his parents begin to suspect that Jesse may be on drugs or mentally disturbed.
The following night, Jesse goes to Lisa’s pool party and kisses her in the cabana. His body begins to change uncontrollably and he leaves in a panic. Lisa’s friend Kerry insists she go after him, but she decides to stay. Jesse goes to Grady’s house and confesses to killing Schneider. He tells Grady to watch him as he sleeps and to stop him if he tries to leave. Grady eventually falls asleep, and Jesse undergoes a painful transformation. Freddy emerges from Jesse’s body and approaches Grady, whose bedroom door jams. He stabs Grady, pinning him to his bedroom door, killing him. Freddy changes back to Jesse who is looking at Freddy’s reflection in Grady’s mirror. He flees before Grady’s parents enter the room.
Returning to Lisa’s house, Jesse tells her what is going on. Lisa realizes that Jesse’s terror is giving Freddy his strength, but he cannot stop fearing him and transforms again. He locks her parents in their bedroom and makes the pool outside start to boil. Freddy attacks Lisa, but realizes he cannot harm her due to Jesse’s influence and he escapes. Outside, Freddy begins to slaughter the teens. Lisa’s father emerges with a shotgun, but Lisa stops him from shooting Freddy, who escapes in a ball of flame. She drives to the factory, facing sudden nightmares that she has to control her fear before confronting Freddy. She pleads to Jesse to fight Freddy, but Freddy’s hold is too strong. Only when Lisa confesses her love for Jesse and kisses Freddy does Jesse begin to fight back. Freddy combusts and turns to ash, as Lisa watches. After he dies, Jesse emerges from under the ashes and the two reunite.
Later, as Jesse, Lisa and Kerry are taking the bus to school, Jesse begins to notice similarities to his original nightmare and panics. After Lisa finally calms Jesse down, Kerry says that it is all over just before Freddy’s clawed arm bursts through her chest. Freddy laughs as the bus drives into the field, just as in Jesse’s first nightmare.