Following up the previous Nightmare film, the dream demon Freddy Krueger is resurrected from his apparent demise, and rapidly tracks down and kills all three of the surviving Elm Street kids. However, Kristen (who has the ability to draw others into her dreams) wills her special ability to her friend Alice before her demise. Afterwords, Alice soon realizes that Freddy is taking advantage of that unknown power she now wields to pull a new group of teenage children into his foul domain.

Picking up where the original Nightmare left off, Nancy has grown up and become a psychiatrist specializing in dream therapy. She meets a group of children at a local hospital facing Freddy Krueger, the same demon she once encountered in her sleep. One of them is Kristen, who has the power to draw other people into her dreams. Working with a male doctor assigned to the case, Nancy helps the kids realize their special abilities within the nightmare world. When Freddy captures one of her charges, she leads a rescue attempt into Krueger s domain, in hopes of putting his spirit to rest once and for all.

A new family moves into the house on Elm Street, and before long, the kids are again having nightmares about deceased child murderer Freddy Krueger. This time, Freddy attempts to possess a teenage boy to cause havoc in the real world, and can only be overcome if the boy s sweetheart can master her fear.