Eight years after the events of the last film, Play Pals (Good Guys) has recovered from bad publicity arising from Chucky's murder spree. The company releases a new line of Good Guy dolls and recycles Chucky's remains. However, the soul of serial killer Charles Lee Ray still inhabited the remains, and Chucky is soon revived in a new doll body. During the meeting, one of the members of the boards question about releasing the Good Guy dolls in the stores might caused problems to children; however, Mr. Sullivan tells them that Andy was a disturbed child and forgotten. Chucky is unwittingly given to Play Pals' CEO Mr. Sullivan, whom Chucky tortures and kills using various instruments. In the final moments of Mr. Sullivan's life, Mr. Sullivan is shocked and realizes that Andy was telling the truth. He then uses computer records to relocate Andy Barclay (Justin Whalin).
Still troubled by his past encounters with Chucky, 16-year-old Andy has been sent to Kent Military School. Colonel Cochran (Dakin Matthews), the school's commandant, begrudgingly enrolls Andy, but advises him to forget his "fantasies" about the doll. Inside the school, Andy befriends cadets Harold Aubrey Whitehurst (Dean Jacobson), Ronald Tyler (Jeremy Sylvers), and Kristin DeSilva (Perrey Reeves), for whom he develops romantic feelings. He also meets Brett C. Shelton (Travis Fine), a lieutenant colonel who routinely bullies the cadets.
Not long after Andy arrives, Tyler is asked to deliver a package to his room. Tyler is fascinated with Good Guy dolls after seeing an ad on the TV upon their comeback. After accidentally dropping and ripping Andy's package, he realizes that the package contains a Good Guy doll. Excited, he takes the new toy to the cellar and unwraps it. Once freed, Chucky scolds Tyler for opening the package he was supposed to give to Andy. But realizing he has a new body, he decides to tell Tyler his true identity to take over his body instead. But just as Chucky is about to possess him, they are interrupted by Cochran, who takes the doll away. Cochran throws Chucky into a garbage truck, but Chucky escapes by luring the driver into the truck's compactor and crushing him. That night, Chucky attacks Andy and tells him his plans for taking over Tyler's soul. But before Andy can attack Chucky, Shelton comes in and takes the doll from him. Andy tries to get the doll back by sneaking into Shelton's room, but Shelton catches him in the act. Upon realizing the doll has vanished, Shelton suspects it stolen and forces all the cadets to do exercises in the courtyard as punishment.
Andy tries to warn Tyler about Chucky, but is initially unheeded. At one point, Chucky lures Tyler into playing hide-and-seek in Cochran's office, where he attempts to possess the boy again. However, they are interrupted by DeSilva and, moments later, Cochran himself. When the cadets leave, Cochran is startled by a knife-wielding Chucky, who attempts to scare him off. The resulting shock causes Cochran to suffer a fatal heart attack, much to Chucky's disbelief.
Despite Cochran's death, Shelton declares that the school's annual war games will proceed as planned. However, Chucky secretly replaces the paint bullets of the red team with live ammunition. When the simulation begins, Chucky accosts Tyler, then threatens the boy when he refuses to take part. Tyler stabs Chucky with a pocket knife and flees, trying to find Andy. Chucky then attacks DeSilva and holds her hostage, attempting to lure the teams into fighting each other to save her. Chucky forces Andy to exchange DeSilva for Tyler.
Suddenly, the red team descends upon the area and obliviously opens fire with their live rounds. Shelton is killed in the crossfire. Amidst the chaos, Tyler makes a quick getaway, but before giving chase, Chucky tosses a live grenade at the quarreling cadets. Recognizing the danger, Whitehurst bravely leaps on top of the grenade and sacrifices himself to save the others leaving his love interest, Cadet Ivers crying because of his death. With no time to mourn his friend, Andy heads off in pursuit of Chucky, with DeSilva close behind.
Eventually the chase leads the group into a haunted house at a nearby carnival. Tyler tries to get a security guard to help him, but Chucky kills the guard off screen and kidnaps Tyler. In the ensuing melee, Chucky shoots DeSilva in the leg, leaving Andy to fight Chucky alone, once again. A scythe in the house cuts Chucky's face. When Tyler is inadvertently knocked out, Chucky seizes the opportunity to possess him, but Andy intervenes, shooting him several times. Enraged, Chucky attempts to strangle Andy, but Andy uses Tyler's knife to cut off Chucky's hand, dropping him into a giant fan which slices him to pieces. Afterwards, Andy is taken away by the police for questioning, but ensures DeSilva that he will be okay, as he's "dealt with them before". As the police car drives away, DeSilva is taken to the nearby hospital and Tyler's fate is never revealed. At the end of the movie, a janitor walks around the park cleaning up the place while all the rides are shutting down. He then walks towards the haunted house, where Chucky was killed.
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