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It has been five years since the events of the first film. A new family, the Walshes, have moved into the former home of Nancy Thompson. The son, Jesse, happens to move into Nancy's old room. He eventually begins to have nightmares of Freddy Krueger demanding that Jesse kill for him using Jesse as a host body to come back to life in the real world.

Jesse's girlfriend, Lisa, finds Nancy's old diary in Jesse's closet in which she had been keeping track of her nightmares and her encounters with Freddy. Reading the diary strikes a chord with Jesse as he is experiencing similar nightmares himself. He goes to his parents in a panic, but they argue and Jesse storms out.

Jesse later finds himself walking the streets late at night and walks into a bar where he runs into his gym coach. His coach takes him back to the gym to run laps as detention. The coach has Jesse hit the showers while he goes back to his office. While he is in his office, the shelves begin to come alive, hurling balls and other sports equipment at him. Two ropes grab him by the wrists and drag him into the shower. The shower fills with steam and we see Freddy's silhouette in the background, clawing the coach's back. As everything comes into focus, Jesse is the one with the glove on his hand.

Lisa begins to do some digging and uncovers information about Krueger, including the location of the abandoned power plant where he used to work, and where he brought his victims. Meanwhile, Freddy visits Jesse's younger sister, Angela, but when she wakes up, it's actually Jesse standing there with the glove on his hand. Jesse enlists his classmate, Ron Grady, to watch over him while he sleeps. Once Jesse falls asleep, Grady turns out the lights for himself. As soon as Grady is asleep, Jesse awakens and begins to scream in pain – Krueger is coming out and Jesse cannot stop him. With the door jammed, Grady is helpless against Krueger, who impales him on his own door with his glove. When Krueger looks in the mirror it turns out that it was Jesse, with Krueger's silhouette staring back at him from the mirror.

Jesse runs to Lisa's house where she is having a pool party. However, Freddy takes control of Jesse and attacks Lisa. Lisa is able to fight off Freddy, who runs from the house and out to the party. Most of the kids run for the fence, only to be confronted by scorching hot metal. Everything begins to heat up, including the pool, burning anyone that is near. Some of them try to take Freddy down, but are killed immediately. Freddy has them all cornered against the back fence; he exclaims, "You are all my children now!" After Lisa saves him from being shot by her father, he vanishes into a fiery ball.

Lisa runs to the old power plant, thinking she might save Jesse there. She finds him and tells him that she loves him and that he can fight from the inside. She then removes Freddy's hat and kisses him. Freddy begins to lose control. As the power plant begins to burn to the ground, Freddy himself starts burning. After he dies, the rest of the power plant suddenly extinguishes. Just when Lisa thinks it is all over, Freddy's burnt corpse begins to move and Jesse crawls out of Freddy's ashes.

The following Monday, Jesse goes back to school. He climbs the bus, finally relieved that it is all over. When the bus begins traveling too fast, Jesse panics and jumps up, only to find out there is nothing wrong; the bus is coming to its regular stop. As he and Lisa rest at ease, Freddy's glove bursts through their friend Kerry's chest and the bus speeds off the main road and into the open land, just like in Jesse's nightmares.

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