Kristen, Joey, and Kincaid have been released from the Westin Hills Asylum and are now living normal lives and attending high school. Kristen has managed to make some new friends: Alice, a young, bright girl who is a frequent daydreamer; Sheila, a brainy, quiet girl with asthma; and Debbie, a tough girl who hates bugs. She has also found herself a boyfriend, Rick, a martial arts enthusiast who is also Alice's brother.
Kristen begins to have bad dreams and feels as though Freddy has once again come back from the dead. During one of her nightmares, she pulls Kincaid and Joey into her dream as she explores the deserted Elm Street house. In school the next day, Kincaid and Joey confront Kristen about pulling them into the dream.
Kincaid wakes up one night and finds himself locked in the trunk of an old junked car. When he opens the hood, he realizes that he is in the same salvage yard that Freddy's body was buried in. Kincaid spies his dog, Jason, digging and urinating in the ground nearby. Freddy then resurrects from the ground after which a pile of junked cars crash down on him. Freddy quickly recoups and kills Kincaid. Later that night Joey is also killed by Freddy.
The following day at school, Kristen is concerned when her friends fail to show up for class. She confides to Alice about nightmares. Kristen hits her head and passes out when she discovers both her friends missing, being attacked by Freddy but revived in time. After she learns of the deaths of Kincaid and Joey, Kristen goes to the actual Elm Street house, with Rick, Dan, and Alice. Rick tells Dan the story of Freddy, and Alice reveals a part of the dream master spell. Alice suggests to Kristen that she is in control of her own dreams. However, Alice also looks down at the ground and sees something, a chalk drawing of the house, that only Kristen has been able to see. Clearly, she senses something. At home that night, her mother gives her a sedative to help her sleep. When Kristen falls asleep this time, on Alice's advice, she tries to convert nightmares into pleasant dreams, to no avail. While she meets a child named Alice in her dream, creating a sand castle, even in her good dreams, Freddy appears and ruins everything. Kristen eventually finds herself in Freddy's boiler room. It is explained that Kristen is the last child from Elm Street, and Freddy needs her help to get more children. When Freddy is about to kill her, she screams for Alice. Alice appears suddenly in the boiler room just as Krueger kills Kristen by throwing her into fire. Before Kristen dies, she sends her power, the power to pull people into her dreams, to Alice. Before the power can reach her, it passes through Freddy first.
Alice awakens immediately, realizing that Kristen's in danger. She turns out to be right, as Kristen's room is on fire. As Alice tries to understand what has happened, and who exactly Freddy is, her friends begin to die. First, Sheila and Rick are killed. While taking a test, Alice accidentally pulls Sheila into a dream where Freddy is waiting; the same thing happens to Rick later. Yet, after every death, including Kristen's, Alice picks up new talents and abilities. She also picks up the dream powers of the children who have died. She is obviously Freddy's supernatural opposite, albeit too weak to truly conquer or even resist him yet. After his death, Alice teams up with Dan Jordan, who was one of Rick's closest friends. Together with Dan, Alice tries to get to Debbie, their last surviving friend, before Freddy finds her. Unbeknown to the two teens, Freddy is able to control their movements. Trapping Alice and Dan in a time loop, Freddy is able to reach Debbie and kill her (by transforming her into a cockroach and trapping her inside a roach motel and then crushing her) before Alice and Dan intervene.
Following a car accident, where Dan is injured and rushed to the hospital, Alice returns home to prepare for one final battle with Freddy. Alice goes to sleep to help Dan before Freddy can kill him. As Alice and Dan search for Freddy, Dan is injured. Alice wills him awake right at the moment the doctors wake Dan and he is pulled from the dreamworld. Alice, facing Freddy alone, attempts to use all of her newly absorbed abilities against him. The fight is relatively equal, except that she has a mortal body and he has not, giving him the advantage of immortality. It's an advantage that proves nearly too great to overcome. He declares that he's been guarding his gate for too long to be taken down by her. But just as he is preparing to kill her, she recalls the final verse of the dream master spell. For the first and only time, someone defeats Freddy, by using the power of the spell to make him see the evil that is inside. Using her power as guardian of the gate of good dreams (which Kristen never was, nor was Nancy,) Alice releases the tortured souls that Freddy imprisoned into the gates of good dreams where he can no longer harm them. Krueger's clothes fall lifelessly to the floor. The film ends with Dan and Alice at a fountain some time later. She tosses a coin in and makes a wish. As she and Dan depart, she decides to keep the wish to herself as Freddy's image appears in the ripples left in the fountain from the tossed coin.