While at the Springwood Diner with his girlfriend, Kris Fowles (Katie Cassidy), Dean Russell (Kellan Lutz) falls asleep at the table and meets a man covered in burn scars, wearing a red and green sweater and a clawed glove on his hand. The burned man cuts Dean's throat in the dream, but in reality it appears that Dean is cutting his own throat as friend and waitress Nancy Holbrook (Rooney Mara) looks on with Kris.
At Dean's funeral, Kris sees a photograph of her and Dean as children, but cannot recall ever knowing Dean before high school. Kris begins to dream about the burned man herself and refuses to go to sleep for fear that she will die in her dreams. Jesse Braun (Thomas Dekker), Kris's ex-boyfriend, shows up at her house to keep her company while she sleeps, but Kris meets the burned man in her dreams and she too is murdered. Covered in blood, Jesse runs to Nancy's house to try to explain what happened and he learns that Nancy has been having dreams about the same man; that man's name is Freddy (Jackie Earle Haley).
Jesse is apprehended by the police under suspicion of murdering Kris, and he is killed by Freddy when he falls asleep in his jail cell. With her friends dying, Nancy begins to question what everyone's connection is to each other, given that none of them can remember each other before their teenage years. Eventually, Nancy and her friend Quentin Smith (Kyle Gallner) discover that all of them, including more children, attended the same preschool together. Nancy's mother Gwen (Connie Britton) reluctantly tells Nancy and Quentin that there was a gardener at the pre-school, named Fred Krueger, who hurt Nancy and the rest of the kids. Gwen explains that Nancy was his favorite, and came home one day telling her mom about Freddy's "magic cave" and the things that happened down there. Gwen claims Krueger skipped town before he was arrested. Nancy does not believe her and attempts to track down the remaining kids from the school. Nancy eventually discovers that all of the other kids have been killed, most of them in their sleep.
Meanwhile, Quentin tries to accept that everything is nothing more than repressed memories, but he falls asleep during swim practice and witnesses what really happened to Krueger. Quentin sees everyone's parents hunt down Krueger, and then burn him alive. Quentin and Nancy confront Quentin's father, Alan Smith (Clancy Brown), about the reality they murdered Krueger with no actual evidence that he had committed any crime. Nancy and Quentin, who both begin sporadically dreaming while they are awake as a result of insomnia, decide to go to the preschool and learn what they can about Krueger.
On the way, Nancy falls asleep and is attacked by Freddy, but when Quentin wakes her up they discover she has pulled a piece of Freddy's sweater out of the dreamworld and into reality. Quentin takes Nancy to the hospital for cuts on her arm; there, he steals some adrenaline and a syringe to help them stay awake. Nancy and Quentin leave the hospital and eventually make it to the pre-school.
Quentin uncovers Krueger's "magic cave" and the evidence that proves Krueger was physically and sexually abusing all of the children. Nancy decides the only way to end this is to pull Krueger out of their dreams and kill him in reality. Quentin tries to stay awake long enough to pull Nancy out of her dream when she has Freddy, but he falls asleep and is attacked. Krueger then goes after Nancy, and explains that he intentionally left her for last so she would stay awake long enough that when she finally fell asleep, she would no longer be able to wake back up.
While Nancy struggles with Freddy, Quentin wakes and uses the adrenaline to bring Nancy up and pull Freddy into reality. With Krueger distracted by Quentin, Nancy uses a broken paper cutter blade to cut Freddy's gloved hand off, and then slice his throat. Afterward, Nancy torches the secret room, with Krueger's body left inside, while she and Quentin leave. Nancy and her mother return home from the hospital, with Nancy being told she should get some sleep. Krueger suddenly appears in a mirror's reflection and kills Nancy's mother before pulling her body through the mirror while Nancy screams.