Just as the first film opened with the creation of Freddy's infamous glove, New Nightmare opens with the creation of an updated, more sinister and sleeker looking glove. As the maker of the claws appears to chop off his own hand in preparation for attaching the claws to his own wrist, the other people on the set wince, and the director, Wes Craven, encourages the effects specialists to pump more blood. Soon he yells, "Cut! Print that Gretchen!" Heather Langenkamp, her husband, Chase, and their son, Dylan, are wandering around the set of the new Nightmare on Elm Street movie.
Presently the claw, which was only a prop a minute ago, comes to life and starts maiming and killing the special effects crew. Dylan is now gone, and as the claw advances to attack Chase, Heather screams waking up in her own bed in her own house with Chase, during an earthquake in Los Angeles. After the earthquake dies down Chase has a couple of scratches, which are the very same as he had received in the dream. This causes Heather to wonder if they were sustained in the earthquake or during the dream. Heather reveals she has been receiving harassing phone calls from "someone who sounds an awful lot like Freddy", but they've stopped for the last couple weeks until now.
Heather is a guest on a morning talk show the very same day, where they discuss the 10th anniversary of the "Nightmare" films. Also, as part of the talk show line-up, Robert Englund as himself tears through a screen dressed up as Freddy Krueger to surprise Heather, Heather is slightly disturbed by this. Producer Bob Shaye asks Heather to visit his office at New Line Cinema, and explains that Wes Craven is working on a script for the new and final "Nightmare" film. Heather is asked to reprise her role as main character "Nancy", but decides against it with her own recent nightmares, disturbing phone calls, and disgruntlement over her son's change in behavior. Bob explains that her husband Chase Porter is also working on the film and he is creating a scary new glove for Freddy, much to Heather's dismay.
When she gets home, her son has an episode during which he warns her in a voice not of his own, "Never sleep again!" Worried, Heather asks Chase to come home, however Chase falls asleep at the wheel on the way and dies supposedly in a car crash. When Heather goes to identify the body, it seems to her that there may have been more than meets the eye to the "crash", as was made apparent by the claw-like marks on his chest. Dylan, now also grief stricken, continues acting even more strangely.
She enlists Wes Craven's help for making sense of what's happening. Craven explains that he does not know much more than she does. He dreams a scene each night and wakes up and writes them down. Craven goes on to tell her that in the script he's writing, pure evil can be defeated if its essence is captured in a work of art that is able to allow evil to express itself. Craven explains that the evil has taken the form of Freddy Krueger because it is a familiar one. "Freddy" sees her as the gatekeeper who holds Freddy at bay, since Heather's character Nancy defeated Freddy in the first movie who in turn eliminated Nancy in the third, but still couldn't be released. To Freddy it is Heather that gave the character of Nancy her strength. Freddy is attacking her at her weakest points, trying to break her down before confronting her, prompting her to leave just as confused as when she arrived.
After a short sleep in Dylan's room, Heather wakes to discover Dylan is gone, she goes downstairs and finds Dylan in another episode. Heather takes Dylan to the hospital, there a doctor asks if Dylan said anything during his trance, Heather says "No" but the doctor later gets it out of her that Dylan has been doing Freddy-like actions and singing Freddy's theme. Later, Julie (Dylan's babysitter) shows up at the hospital and tells Heather she had a nightmare about him. Soon, two nurses want to sedate Dylan, but Julie had instructed by Heather to not let Dylan fall asleep while she goes home to get Rex. Julie punches the nurse and threatening another with a needle (cameo appearance by Wes Craven's daughter), and locks the door. Meanwhile, Heather tried to leave but been stopped by security to be questioned by the doctor, the doctor suspects Heather is insane, and tries to agree to foster care. Next, Dylan drifts to sleep, Freddy appears in the locked hospital room and brutally slays Julie (in the same fate as Tina Gray in the first film). The nurses unlock the doors, and discover the murder. They run, but Heather is concerned where Dylan went, the doctor realizes Heather is right. Heather soon remembers home, (previously she comforted Dylan by telling him their home is right across the freeway from the hospital). She discovers a giant Freddy dangling Dylan from above traffic. She arrives home and finds Dylan, but Freddy begins to manipulate the world, causing her to become Nancy. By forcing Heather to accept the role he wants her to play, Freddy rises out from Dylan's bed and is fully in the real world. Heather runs inside and into Dylan's room only to find him gone, and the toy dinosaur Dylan believed was protecting him totally eviscerated by Freddy.
Heather takes sleeping pills to join in on a dream, final showdown with Freddy to save an already captured Dylan. It occurs in a hot, steamy and water-logged dreamscape ruin, apparently Freddy's home turf. Dylan finds Heather, only for them both to be attacked by Freddy, Heather is knocked out, Dylan is left in defenselessness.
Freddy lures Dylan into a trap and tries to attack him vigorously, Heather discovers the battle and fights off Freddy, but Freddy makes his tongue extend and wrap around her face. Dylan gets out of the trap to save Heather by taking a large kitchen knife that she brought in with her, stabbing Freddy's tongue and making it go back to its previous size. The two succeed in killing Freddy, by locking him in a lit furnace where upon catching on fire, (in a Hansel and Gretel- ending) his true visage is shown amidst a fiery blast, all the while Dylan & Heather flee, escaping back to reality, where they find the script of the film Craven has been working on, waiting for them. Dylan asks his mother to read, which she does: "We open on an old wooden bench. There's fire and tools, and a man's grimy hands building what's soon revealed as a gleaming set of claws. And the claws are moving now as if awakening from a long and unwanted sleep...."