Plot

In September 1985, John Kreese (Martin Kove), broke and destitute after the loss of his students, visits his Vietnam War comrade, Terry Silver (Thomas Ian Griffith), a wealthy businessman who founded Cobra Kai and is the owner of a toxic-waste disposal business. Silver vows to personally help him get revenge on Daniel (Ralph Macchio) and Mr. Miyagi (Noriyuki "Pat" Morita) and re-establish Cobra Kai, sending Kreese on vacation to Tahiti to rest and recuperate.

Upon returning to Los Angeles from Okinawa, Daniel and Miyagi discover that the South Seas apartment complex is being renovated, leaving Miyagi unemployed and Daniel homeless. They also learn that Daniel's mother, Lucille (Randee Heller), is currently in New Jersey taking care of Daniel's ill Uncle Louie (Joseph V. Perry). Miyagi invites Daniel to stay at his house, and Daniel uses his college funds to help finance Miyagi's dream of opening a bonsai shop. Miyagi makes him a partner at the business. Visiting a pottery store across the street, Daniel meets Jessica Andrews (Robyn Lively); although he has a brief crush on her, she tells him that she's not available and they agree to just be friends.

Silver hires Mike Barnes (Sean Kanan), a vicious karate prospect nicknamed "Karate's Badboy", to challenge Daniel at the upcoming All-Valley Karate Tournament. Silver had offered 25% ownership in his new Dojos to Barnes if he beats Daniel, but Barnes gets greedy and wants 50%. Silver sneaks into Miyagi's house to gather information and overhears Daniel telling Miyagi that he decided not to defend his title at the tournament. Barnes and his henchmen Snake (Jonathan Avildsen) and Dennis (William Christopher Ford) harass Daniel in an attempt to force him to enter the tournament, but Daniel still refuses, and Barnes departs in a rage.

The next morning, as Daniel and Miyagi are practicing Kata, Silver interrupts their training and lies about John Kreese suffering a fatal heart attack after losing his students and begs forgiveness for Kreese's behavior. Barnes, Snake and Dennis return to make Daniel sign up for the tournament; when Daniel again refuses, a fight ensues until Miyagi arrives and fends off the three men. After driving Jessica home, Daniel and Miyagi return to find their stock of bonsai trees missing and a tournament application hanging in place. Although Daniel reports the theft to the police, they do not take him seriously.

To replace the missing trees, Daniel and Jessica decide to dig up and sell a valuable bonsai tree that Miyagi brought from Okinawa and planted halfway down a cliff. As they retrieve it, Barnes and his henchmen appear and retract their climbing ropes, leaving Daniel no choice but to sign up for the tournament. After pulling them back up, Barnes breaks the tree. Daniel returns to the shop with Miyagi's damaged bonsai, which Miyagi attempts to mend. Miyagi tells Daniel that he sold his truck to buy a new stock of trees and refuses to train him for the tournament.

Silver offers to "train" Daniel for the tournament at the Cobra Kai Dojo with a series of brutal, violent, and offensive techniques. He derides Miyagi's Kata forms and pressures Daniel to destroy a wooden practice dummy, causing him several injuries in the process. Throughout his training, Daniel's frustration alienates him from Miyagi. While Daniel and Jessica are at a nightclub, Silver bribes a random man into provoking a fight with Daniel, who responds by punching the man and breaking his nose. Shocked by his aggressive behavior, Daniel apologizes and makes amends with Jessica and Miyagi.

Daniel visits Silver to inform him that he will not compete at the tournament, but Silver reveals his true agenda to Daniel as Barnes enters the Dojo. Daniel attempts to leave, but Kreese leaps out to intercept him, revealing himself to have been alive all along. After Barnes viciously attacks Daniel, Miyagi intervenes and easily defeats Kreese, Silver, and Barnes. Miyagi finally agrees to train Daniel after learning of their plot. They replant the healed bonsai and begin training.

At the tournament, Barnes reaches the final round to challenge Daniel. Silver and Kreese instruct Barnes to inflict serious damage on Daniel, keep the score a tie, and finally beat him in sudden death. Barnes gains the upper hand during the fight while taunting Daniel relentlessly. When the initial round concludes, Daniel wants to quit, but Mr. Miyagi urges him to continue, saying that his best karate is still inside of him.

In the sudden death round, Daniel performs the Kata, effectively confusing Barnes. Urged on by Kreese and Silver, Barnes lunges toward Daniel to claim the final point, but Daniel flips him to the ground and strikes him to win the tournament. Silver leaves in disgust while the crowd throws back their Cobra Kai T-shirts, as Daniel and Miyagi embrace and celebrate victory.