Marge sends Nancy to bed, but Nancy is now afraid to sleep. She drinks coffee constantly and has a fresh pot hidden in her room, just in case.
Nancy enlists Glen's help in an experiment. It appears as if she asks Glen to follow her, but she is in her nightclothes, so we presume she is dreaming.
Nancy goes to the jail where Rod is being held, and by peering in the window she can see his cell.
Rod is asleep, and she can see the killer approaching him, walking right through the bars of Rod's cell. Nancy yells for Glen but he is no longer there; instead, the voice of the killer answers "I'm here, Nancy!" and he lunges at her, chasing her back to her house.
She runs inside and finds she cannot escape because her stairs have suddenly turned into a sticky mess. The killer smashes the window on the front door and peers inside as Nancy struggles to get away; he is wearing Tina's face as a mask, and imitating her voice, he says "Nancy, help me, please! Save me from Freddy!"
Nancy wakes up, and she is furious to find Glen asleep next to her bed, as she had asked him to keep watch and wake her if it looked like she was having a nightmare. Nancy and Glen hurry over to the jail to see Rod, as Nancy is convinced the killer is going to strike. Sure enough, before they can intervene, Rod's nightmare becomes real and an unseen hand twists his bedsheets around his neck, stringing him up in his cell and breaking his neck.
Lt. Thompson is skeptical of Nancy's claims that they are being haunted in their dreams, as it appears Rod simply hung himself.
Both Marge and Lt. Thompson seem to share an unspoken realization about Nancy's allegations, but they will not admit anything to Nancy.
Instead, Marge takes Nancy to a sleep clinic where they monitor her body as she sleeps.
Her nightmare sends the instruments haywire because of its intensity, and when they wake Nancy up, she has a sudden gray streak in her hair from terror.
There is another shock for all of them: Nancy is inexplicably holding the killer's Fedora. She says she was holding onto it when she woke up.
Nancy's mother continues to deny that anything strange is going on, and she insists that Nancy get some sleep. Instead Nancy produces the Fedora and points out that it has a name written inside: Fred Krueger. Marge denies knowing who that is, and Nancy reacts angrily.
Nancy has a conversation with Glen where Glen tells her that certain zen masters could control their dreams. Nancy asks what they would do if they met a monster in their dreams, and Glen says they would turn their back on it. If you take away a nightmare's energy, it disappears. Glen is surprised that Nancy believes she will die because of a nightmare, and also that she is reading books on creating booby traps and survival techniques.
Nancy's mother finally opens up to her and tells her the truth. Taking Nancy down into their own basement, Marge tells her about Fred Krueger, who was a murderer that preyed on young children. When Krueger was apprehended, a technicality (being an improperly signed search warrant) caused the evidence against him to be inadmissable, and he was not convicted and was hence, released from prison.
As a result, she and Nancy's father, along with other parents in the neighborhood, murdered Krueger on their own by setting him on fire.Marge reaches into the furnace and removes a dirty bundle; unwrapping it, she produces Freddy's glove, which she took the night they murdered him. Nancy realizes that Freddy is out for revenge, somehow reaching from beyond the grave to murder them in their dreams.
Nancy tries to warn Glen but his parents will not allow her to talk to him. She receives a taunting phone call from Kreuger, even after she rips the phone out of the wall, and she realizes that Glen is about to die. Nancy can't rescue him because her mother has placed metal bars on all the windows and doors.
Glen falls asleep and is killed by Freddy, being sucked into his bed and apparently shredded until nothing is left but gore, which erupts into a horrible fountain all over his bedroom.
Nancy realizes she is now alone and must face Freddy or die. Calling her father, she tells him that she is going to go and get Freddy and bring him out of her dream, and she wants her father to be there to arrest Freddy when she does.
Lt. Thompson doesn't believe her, but he patronizes her so that she will go to sleep. Nancy sets up a number of booby traps in the house for Freddy in order to give herself an advantage after she 'captures' him.
After saying goodnight to her mother, who is now completely drunk, Nancy falls asleep and goes down into her basement. There she finds a door that was never really there before, and it leads down a long staircase into another basement. She continues to climb further and further downwards, following ladders and stairwells, until she is in Freddy's boiler room.
Freddy is nowhere to be found, and time is running out before Nancy's alarm goes off and wakes her up. Finally he attacks her and she struggles with him; her nightmare suddenly shifts and they are outside of her house. Nancy's scheme succeeds, and she brings Freddy into the real world, holding onto him as her alarm goes off. The booby traps she has rigged for Freddy help her get an edge on him, but she is unable to get the attention of her father; the cop he has posted to watch Nancy's house seems to be unable to understand that Nancy needs help.
Freddy chases Nancy through her house and down into her basement, where she sets him on fire. Lt. Thompson breaks into the house, but he and Nancy are shocked to see fiery footprints leading out of the basement.
They follow the trail upstairs and find Freddy struggling with Marge in her bed. When they pull back the bedclothes, Freddy is gone.
Marge is nothing but a charred corpse, and the body disappears into the bed. The supernatural manifestation shocks Lt. Thompson, but Nancy seems resolute.
She asks to be alone for a moment and when Lt. Thompson leaves, Freddy appears, rising up out of the bed.
Nancy turns her back on him this time, remembering what Glen told her. She curses Freddy, telling him "You're nothing. You're shit."
He lunges at her, but her lack of fear renders him powerless, and he vanishes into thin air.
Nancy leaves the bedroom and suddenly finds herself outside, dressed for school. Marge stands on the porch and sees Nancy off to school in a loving way, telling Nancy that she is going to quit drinking. Glen, Rod, and Tina pull up in Glen's car to take Nancy to school. When Nancy gets in, the convertible roof suddenly slams shut over their heads; the roof is red and green, like Freddy's sweater.
The windows go up and the car drives off, with all four of them trapped inside. Marge seems oblivious, waving goodbye to the kids, when suddenly Freddy's arm smashes outwards through the small window in the front door. In a bizarre movement, Marge's entire body is pulled through the tiny window, and she is gone