Freddy narrates that he is trapped in Hell, due to the fact that the citizens of Springwood have mostly forgotten him over time, as well as the fact that the adults have kept the current generation of teenagers ignorant of Krueger's existence, leaving him powerless to return to their nightmares. Hoping to inspire the citizens of Springwood to fear him again, he manipulates Jason Voorhees, (after being dead for two years following the events of Jason Goes To Hell) under the guise of his mother, that the children on Elm Street have been very bad, and sends him to begin killing them, hoping that the fear inspired by the mass murder will bring his powers back.
Meanwhile, Lori Campbell who now lives at 1428 Elm Street with her widowed father, is visited by her friends Kia, Gibb, Trey, and Blake, who are planning to spend the night at her house. Trey is killed by Jason who stabs him in the back repeatedly before folding him in half while Gibb is in the shower. The gruesomeness of the murder and the fact that it happened in bed has police speculate that it was Freddy who had killed him. Lori overhears his name, and while at the police station she has a nightmare where she is scared by Freddy. Later, Blake has a nightmare where Freddy tries to attack him, but he escapes unharmed as Freddy is not powerful enough yet to kill him. He wakes to discover his father beheaded beside him before Jason appears and kills him by hacking him to pieces. The next day, the murders are blamed on Blake who they state committed suicide afterward.
At Westin Hills Psychiatric Hospital, Lori's ex-boyfriend Will Rollins and his friend Mark are patients, being fed Hypnocil to suppress their dreams as being the last of the people who have had contact with Freddy. Will suspects he was sent there after seeing Lori's father murdering his wife. After seeing a news report of the murders, Mark concocts a plan that allows the two of them to escape. They return to Springwood and Mark abruptly tells Lori and the others about Freddy, then later realizes the city's plan of erasing Freddy by making the population forget about him and that he may have ruined their plan. That night, Lori and the others attend a rave located at a cornfield. Gibb, after drinking too much while grieving over Trey's death, sees him and follows him to an abandoned silo which turns out to be dream and a trap set by Freddy. As he is about to kill her, Jason, who had invaded the rave and was killing all of the partygoers, kills her by impaling her with a broken pipe in the real world. Robbed of his victim, Freddy realizes that Jason will not stop killing and stealing his potential victims. Linderman, a classmate who has a crush on Kia, and stoner Freeburg escape the rave unharmed along with Lori.
Lori approaches her father about her mother's death and traps him in a lie. After she leaves the house, she and Will go to Mark's house only to discover to their horror that he is being attacked by Freddy who burns and then slashes Mark's face with his bladed glove. Meanwhile, Deputy Stubbs suspects a copycat Jason murderer, but his suspicions fall on deaf ears. He then approaches Lori and her friends; Linderman realizes that Jason was real. With two killers hunting them, there seems to be nothing they can do until they learn about the Hypnocil at Westin Hills. They go to the hospital to obtain a supply of Hypnocil, but Freddy possesses Freeburg to dispose the drugs via pouring them down a sink. After Jason electrocutes Stubbs, he is tranquilized by the Freddy-possessed Freeburg, who Jason promptly cuts in half before succumbing to the drugs.
The teens then come up with a plan to pull Freddy from the dream world and force the two killers into a battle with each other. They take the unconscious Jason to Crystal Lake, PA to give him the home field advantage and should he defeat Freddy there; he'll already be back at his home and thus, will not come after the teens. Meanwhile, Freddy attempts to murder Jason in his dreams. But due to his apparent lack of fears, combined with his real world indestructibility, Jason proves impossible for Freddy kill even in the dream world. Freddy then discovers Jason's fear of water and uses it to pull him into a nightmare of his drowning as a child. Lori enters the dream world to retrieve Freddy, saving Jason in the process. Enraged by this, Freddy attacks Lori, revealing that he was the one who killed her mother, not her father.
In the real world, Jason awakens and stalks the others through Crystal Lake, chasing them to a nearby cabin. Linderman is mortally wounded when Jason pushes him away and gets impaled on a self bracket in the process and the cabin catch fire. Lori's hand is dragged through some flames which causes her to wake up and pull Freddy from her dream into the real world while the others escape with a dying Linderman who dies of blood loss later on. Freddy and Jason begin to fight just as planned, Jason using his immense strength and taking advantage of Freddy's fear of fire to get the upper hand. Freddy keeps ahead of Jason using his speed, agility and cunning. While trying to escape, Kia taunts Freddy to distract him from Lori and Will, but she is blindsided by Jason who slashes her across the chest causing to fly into a tree, killing her . Unwilling to leave until she sees Freddy die, Lori and Will watch the combat between the two horror titans. Jason rips Freddy's arm off as Freddy gains control of Jason's machete and severely wounds him in return, throwing him into the lake. He turns to Lori, intent on killing her, but is stabbed through his torso by his own bladed arm by Jason. Jason repaid Lori because she saved him in the dreamworld. Lori decapitates Freddy with the machete and both Freddy and Jason fall into the lake, dead. Finally at peace with their past, Lori and Will leave Crystal Lake together. Soon after Jason emerges from the lake holding Freddy's head in his hand in victory. As the camera zooms in on Freddy's head, it winks and laughs.