Set outside the canon of the previous Nightmare on Elm Street films, Craven's New Nightmare is a post modern take on the horror genre that depicts the effect that horror films have on those who make them.
The basic premise was originally intended for Nightmare on Elm Street 3, but was rejected at the time.
The movie begins in the "real world," in which Heather Langenkamp and Wes Craven are filming a new sequel to A Nightmare on Elm Street. Suddenly, a special effect turns deadly when robotic Freddy Krueger claws begin attacking the cast and crew. Heather then wakes up in bed with her husband in the midst of an earthquake, realizing that the horrible accident was just a dream, but also noticing that her husband's hand has been cut, just as it had in the dream.
As her husband leaves to go on a work-related trip, it is revealed that she has been receiving threatening phone calls in the vein of the original Nightmare on Elm Street. After her husband leaves, her son Dylan sees a small scene from A Nightmare on Elm Street, and goes into a fit, screaming uncontrollably. Reluctantly, after her son has calmed down and the earthquakes have subsided, she leaves as well to appear on a talk show, leaving her son with a babysitter. On the show, she talks about how the series had affected her, eventually having a surprise meeting with Robet Englund dressed as Freddy.
After the interview, Heather receives a call from New Line Cinema, to talk about producing a new film. When she gets to the offices, the chief producer offers her a role in a brand new Nightmare on Elm Street movie. She rejects his offer almost immediately after realizing that the production of the new film has been coinciding with her own recent nightmares, threatening phone calls, and Dylan's episodes.
Upon returning home, her son is having another episode, flailing his arms and screaming uncontrollably. After about a minute of this, her son begins to imitate Freddy, and then wakes up from his manic fit. After this, she notices that Dylan's dinosaur toy had been cut while he had been having a nightmare. When Heather calls Chase, he admits to having been working on the new Nightmare movie, and also that the two people she had seen murdered in her dream had not shown up for work.
In another dream, Heather pictures Chase on his way home from the movie set. He begins to fall asleep at the wheel, drifting back and forth across the road when suddenly, Freddy's hand bursts out of the driver's seat, disemboweling him and steering the car into a brick wall. After Heather wakes up, a pair of police officers come to her door, informing her that Chase had been in a fatal car accident.
She then visits the morgue to see his dead body, and see whether or not he had actually been killed by Freddy Kreuger. She discovers claw marks across his chest, which she instantly recognizes as Freddy's, confirming her suspicion that her dream had been true. In another dream sequence, she sees Dylan being pulled underground by Freddy at Chase's funeral.
The next night, she discovers Dylan in a trance watching the original movie again, and he begins to scream again when she wakes him, beginning to imitate Freddy soon afterwards. He then describes how freddy is coming into their world, and begins to bleed from the nose. As she brings him to the bathroom to wash up, it is revealed that the television that he was watching the movie on was not plugged in. Dylan's condition continues to deteriorate, acting stranger and stranger, and interacting with other children less and less. Heather suspects that he is being controlled by an outside force, while her friends assure her that it's just because of her "crazed fan" and the recent death of her husband.
After receiving more phone calls and threatening mail from her stalker, she calls Robert Englund about her continuing visions. They talk over the phone, describing the Freddy that they have been seeing as "Darker, and more evil." It is suggested that Robert has been having similar nightmares. That night, while she sleeps, Freddy's new claw, made by Chase before he died, emerges from Heather's bed, coming inches from her face before she wakes up. Her son attacks her with knives taped to his fingers, imitating Freddy. She then wakes up, realizing that she had been having a dream within a dream. When she actually wakes up, she sees that her son has arranged the letters she had been receiving to form the statement "answer the phone." When she does, she sees a tongue comes out of the handset, just as had happened in the movie. Just afterwards, Dylan has another episode, this time being admitted to the hospital. At the hospital, he is designated unstable, and is not allowed to come home. He is almost completely unresponsive, but she still explains to him that he must take his medicine and forget about Freddy before he is allowed to leave. After she leaves, Dylan is shown taking his medicine out of his mouth, and hiding it under his pillow. As she drives home, she sees the various buildings and structures destroyed by the recent series of earthquakes.
Heather then meets with Wes Craven, who explains that Freddy is not just a movie character, but an ancient evil entity. The only way to stop this entity, he explains, is by capturing it in a story. Now that the films have ended, Freddy has been released and Heather is the only one who can stop him, by playing Nancy once again for another movie.
When she gets home, she sees a report about the special effects technicians she had seen killed in her dream, apparently found dead in their apartments. Immediately afterwards, another earthquake strikes, destroying her coffee pot and her TV. Then, for the first time in the film, Freddy himself attacks her, bursting out of her closet, and cutting her across the arm.
At the hospital she is treated for her wounds, and then goes to see dylan, who is now in an oxygen tank. In another nightmare sequence, her son is possessed by Freddy, and attacked by the nurses. She wakes up, and finds her son in another hospital room, being taken care of by the babysitter. The nurses, however, will not allow her to take Dylan home, blaming Heather for his condition. Before heather is taken away by hospital security, she urges the babysitter to keep Dylan awake at all costs.
After the Nurses inject Dylan with a sedative without permission, the babysitter is dragged around the walls and ceilings of the room by an invisible Freddy Krueger, who kills her soon after. Dylan then flees the hospital, with Heather chasing him. A gigantic Freddy, toying with Heather, dangles Dylan in front of traffic on a freeway. Freddy puts him down after a minute, and Heather chases Dylan back to their house, where she realizes that she is living in another Nightmare on Elm Street sequel.
Finding a trail of her son's discarded sleeping pills, she takes them one by one, so that she can fall asleep and combat freddy face to face. After taking three or four of them, she gets pulled through her bed, into a hellish world resembling the movie set from the opening of the film. Hearing her son crying for help, she is led to what seems to be a copy of Wes' script, realizing that "there was no movie, there was only her life," as her son runs to her. Suddenly, Freddy attacks them, beginning to fight Heather. After throwing heather into a pool of water, Freddy continues to chase Dylan, slowly extending his arms towards him, and pulling him closer, threatening to "eat you up." In a last ditch effort, with Dylan's help, Heather pushes Freddy into an oven, incinerating him, and causing his hellish dream world to collapse around them.
In the real world, Heather reads a note written by Wes at the end of the script, thanking her for "having the guts to play Nancy one last time." The camera pulls away as she begins to read the script to her son, and the movie ends.