Frank Drebin (Nielsen) has retired from police work and lives a basically happy life with his wife Jane (Presley). It remains "basically happy" because police work has been Frank's meaning of life, and he feels unhappy about not being able to legally take on criminals anymore. Additionally, Jane tries to push him into siring a child, but Frank does not have the courage to go through this yet.
It comes as a blessing to him when his old friends Ed Hocken (Kennedy) and Nordberg (Simpson) come by and ask for his help in an investigation. The Police Squad has caught wind that a well-known bomber named Rocco Dillon (Ward), who is currently incarcerated, has been hired by a terrorist (Papshmir, known from the first movie) to conduct a major terrorist act against the United States. An important contact, Tanya Peters (Smith), Rocco's girlfriend, proves to be a dead end, so Drebin is asked to join Dillon undercover in prison, befriend him, and then leak details of the plan to his colleagues. However, the first part of the mission - by pure accident - proves to be extremely taxing; Jane becomes frustrated both at Frank's sudden unwillingness to engage in his marital duties and the suspicion that he is doing police work again, and storms out of the house.
Frank joins Rocco in prison, and after winning his trust, the two stage their breakout together. Rocco even manages to persuade his dominant and highly distrustful mother Muriel (Freeman) to take Frank into their house. However, both are loth to tell Frank too many details right away, which is why he is forced to stay around a little longer. In the meantime, Jane joins her friend Louise on a wild road trip, but in time she realizes that she really misses Frank. When she returns and finds him missing, she follows a clue Frank had inadvertently left behind to Tanya, where she is promptly taken hostage by Rocco and his mother. Frank is barely able to save her life for the time being, and eventually Rocco reveals his plan: the bomb is to be set off at this year's Academy Award ceremony, with the bomb hidden in the envelope with the nomination of Best Actress and triggered when the card is pulled out.
At the awarding night, Frank and Jane separate from Rocco's team and frantically begin searching for the bomb, with Frank inflicting his usual chaos onstage during the prelude show. They are, however, unable to find the bomb before the nomination for Best Actress is begun. When Frank bursts onto the stage and awkwardly attempts to prevent the detonation of the bomb, Rocco and his mother realize what's going on and take Jane hostage, but in the process Frank loosens an electronic sign which takes out Muriel. Desperate, Rocco decides to detonate the bomb to follow his mother, but Frank manages to catapult him and the bomb out of the awarding hall right into Papshmir's private plane (which was circling overhead), with the bomb eliminating all hostile parties involved. Frank and Jane reaffirm their love under the applause of the awarding audience and viewers worldwide.
About nine months later, Frank and Nordberg rush into the pedriatic ward to witness the birth of Frank's child - only that a slight mistake ends with Frank being very resentful at Nordberg ...