Taking place almost a year after The Dream Master, Alice and Dan have now started dating and there is no sign of Freddy Krueger. Alice begins to have dreams of a young nun, with a name tag for "Amanda Krueger", being locked away in an asylum full of maniacs. Upon graduating from high school, Alice and Dan plan their getaway to Europe. Alice has made some new friends: Greta, a supermodel in training; Yvonne, a future Olympic diver; and Mark, a comic geek.
As Alice makes her way to work she finds herself back at the asylum. Alice is wheeled into an operating room on a stretcher, wearing Amanda's uniform, and screaming in pain. As Alice looks around she sees Amanda Krueger on the table, instead of herself, giving birth. As the baby is delivered, Amanda clamors to get to it. The baby breaks free from the doctors and escapes the room. Alice follows it into a church rectory, the same place that Alice defeated Freddy in the previous film. Before she can stop him, the baby finds Freddy's clothes and quickly grows into an adult. Amanda shows up to help Alice, but she's disrupted when Freddy slams the church doors closed on her. After these events, Alice finds herself at work, but four hours late.
Alice immediately phones Dan who leaves their friends and rushes over to the diner. Before Dan can make it he falls asleep and Freddy forces him to drive into another vehicle. Alice, after watching Freddy take possession of Dan, faints in the middle of the street. At the hospital, she is informed that she is pregnant with Dan's child. While recouping, she meets a young boy, Jacob. Yvonne later informs Alice that there were no children on her floor, nor is there a children's ward at the hospital. Krueger begins to kill Alice's friends one by one as they fall asleep. First is Greta, by forcing her to eat herself to death. Krueger then goes after Mark, and only after Alice drawing herself into Mark's dream does Mark start to believe Alice. Alice requests an early ultrasound for her baby, and she soon realizes that Freddy is using her child to get into her friend's dreams. Alice also discovers that Jacob is really her unborn son. While Alice is looking for Amanda's body, Yvonne is attacked by Krueger. It's only when Yvonne barely escapes Krueger, thanks to a little help from Amanda's soul, that she accepts what Alice has been telling her. Shortly afterwards, Mark finds a comic depicting the entire events to that point and is drawn into his own nightmare. While there, Mark sees an image of Greta and finds his "dream power", the Night Prowler. He attacks Krueger, but is ultimately killed by Krueger and cut to pieces (literally, as he was turned into a paper character in his nightmare).
Alice sends Yvonne to the now-abandoned asylum (former Westin Hills) to release Amanda's soul while she sets out to free Jacob. Krueger pulls her into a M. C. Escher-like labyrinth to try to slow her down. Freddy goes back into hiding inside Alice as she finally catches up to Jacob. Upon the revelation that Krueger has been hiding inside of her the whole time, Alice forces him out, but almost dies in the process. After being released by Yvonne, Amanda arrives and instructs Jacob on how to defeat Freddy. Jacob, releasing the power that Krueger has given him, forces himself and Freddy to revert back to an infant. Alice picks up Jacob and absorbs him while the now-infant Freddy tries to escape. Before he can escape, though, Amanda picks him up and absorbs him back inside. Freddy begins to fight from within and the church doors close. A couple of months go by; Alice gives birth to Jacob, and is finally at peace from the nightmares.
In the film's last scene, the children who appear throughout the series and are used as omens of Freddy's presence are shown, humming the familiar song "One, two, etc..," wearing church outfits. They are next to Alice, her father, Yvonne, and baby Jacob. We then hear Freddy's laugh indicating he may strike again.