Picking up where the first movie left off, the Tall Man and his minions attempt to take Mike (James LeGros), but Reggie (Reggie Bannister) manages to save him after turning on the gas while the fireplace was on, blowing up the house.
Six years later, the film introduces Liz Reynolds (Paula Irvine), a young woman with a psychic bond to Mike Pearson and the Tall Man that manifests in the form of prophetic nightmares. After she awakens from one, she looks at her dream journal, which includes drawings detailing characters and events from the first film; during this, she recalls a vision that picks up immediately where the first film ended: after the Tall Man's minions attacked Mike through his bedroom mirror, Reggie heard the commotion and ran upstairs to his aid. He tried to get a shotgun, but was attacked by Lurkers and had to flee, although he managed to surreptitiously snuff the pilot lights on the stove. Once upstairs, he dodged the Tall Man and rescued Mike, and the two dove out of the bedroom window to escape as the gas fumes reached the living room fireplace and destroyed the house. Following this, Liz pleads for Mike to find her, as she fears that when her grandfather dies, the Tall Man will take him.
Having been institutionalized as delusional since the first film, Mike feels he can no longer ignore Liz's dream pleas, and fakes his recovery to obtain a doctor's release. At night, he returns to Morningside Cemetery to exhume bodies and is interrupted by Reggie who tells him that the attack at the beginning of the film never occurred. Mike reveals that the coffins he dug up are empty and urges Reggie to help him hunt the Tall Man down. En route to Reggie's house, Mike receives a vision of an impending gas explosion, and frantically tries to warn Reggie seconds before his house is consumed in an explosion, killing his wife Celeste, daughter Bonnie, and Aunt Marta. Mike's futile warning convinces Reggie that he is telling the truth and agrees to accompany Mike on his quest.
They break into a hardware store at night and stock up on an abundance of supplies and tools to build weapons including a chainsaw and two double-barrelled shotguns welded together. Over the next several months, Mike and Reggie travel the country roads, encountering abandoned towns and pillaged graveyards, as well as a few traps and apparitions the Tall Man has left. One of them is an apparition of a fully nude deceased young woman. The clues lead them to Perigord, Oregon.
Meanwhile, Liz's grandfather has died and she accompanies her grandmother to the funeral with her sister Jeri, who leaves prematurely and mysteriously vanishes. While searching for her, Liz explores the mortuary and discovers an exhumed coffin, but before she can open it, the Tall Man surprises her and she runs away. The presiding priest Father Meyers (Kenneth Tigar) maddened with fear and alcohol withdrawal, desecrates the grandfather's body with a knife in a desperate attempt to thwart the mysterious occurrences he has witnessed.
That evening, during a bout of drinking, the reanimated grandfather surprises him at his door and then spirits into the grandmother's bed before absconding with her. In the morning, Liz finds the empty bed and a funeral pin; the Tall Man psychically tells her to return at night if she wants to rescue her grandmother.
Prior to their arrival in Perigord, Mike awakens to find that Reggie has picked up a hitchhiker named Alchemy (Samantha Phillips) who eerily resembles the nude apparition. They find Perigord deserted and decrepit, and stop in an abandoned bed & breakfast before venturing out to the cemetery. Liz arrives at the mortuary to search for her grandmother, but is confronted by Father Meyers, who tries to rally her to escape with him but he is killed by a flying sphere. She encounters the Tall Man and discovers that her grandmother is now one of his Lurkers. As she escapes, she and Mike meet in the cemetery and return to the bed & breakfast, where they try to sleep. When a tripped alarm distracts them downstairs, the Tall Man captures Liz, knocks her unconscious and drives her away in his hearse. Mike and Reggie chase him in Mike's deceased brother Jody's car, but the Tall Man runs them off the road and the car explodes.
At the crematorium, Liz slowly regains consciousness while being taken into the furnace room by the Tall Man's mortician assistants. She fakes unconsciousness by allowing the assistant to partially undress her and take her crucifix. She manages to fight off the mortician by sending him into an active furnace and escapes. Mike and Reggie break into the mortuary and venture into the embalming room. As Reggie pours hydrochloric acid into a tank of embalming fluid, Mike discovers that the Tall Man, having learned from his mistakes, has hidden his transdimensional portal (Spacegate) behind a heavy steel door. In lieu of a handle, there is a large round "keyhole" in the wall and Mike realizes that they must capture a sphere in order to access the room. They then split up to find Liz.
Reggie searches the basement where he is attacked by a Graver, then four Lurkers. Mike saves Liz from a flying silver sphere but they are both attacked by the other mortician, who is defeated when the silver sphere pins his hand to a door and he cuts off the hand with an axe in an attempt to escape another sphere. A laser-armed flying golden sphere pursues Mike and Liz but instead kills the second mortician as he tries to catch them.
Reuniting with Reggie, the three pry the mortician's severed hand off the door and carry the embedded silver sphere to the embalming room, where they insert it into the "keyhole" and open the metal door to the white room containing the portal. Reggie ignites the flamethrower to burn the building down, but the Tall Man surprises them, knocking Reggie down, throwing Mike into the portal, and carrying Liz to the embalming table. Reggie helps Mike climb back out, while the Tall Man prepares to embalm Liz alive with a giant probe; Mike pulls the silver sphere from the keyhole and attacks the Tall Man with it unsuccessfully. Liz gets free and stabs the Tall Man with the probe, and Reggie quickly activates the embalming machine, pumping the acid-contaminated fluid into him, causing him to melt. Reggie sets fire to the room and hallways and the trio are greeted at the back entrance by Alchemy, who has procured an abandoned hearse.
They ride off with Mike and Liz in the rear compartment and Reggie and Alchemy in the driver's cabin. Reggie thanks Alchemy for coming back for them and tries to flirt with her until she gently plucks a section of hair and flesh from her head, revealing that she is not human. As Reggie screams, the hearse swerves wildly and Mike and Liz try to get out; the hearse stops and a bloody and battered Reggie hits the window before falling to the ground. As the hearse begins to drive away, Mike and Liz tell each other "this is just a dream" but the slot to the driver's cabin opens, revealing the Tall Man who tells them "No, it's not!"
Hands break the rear window and pull Mike and Liz through it... mirroring the ending of the first film.