Eight years after Chucky's second demise, the Play Pals company has recovered from the bad publicity brought about by Chucky's murder spree and resumes manufacturing of the Good Guys dolls. The company restores the abandoned factory (where Chucky's mutilated body still remains) and starts releasing a new line of Good Guys dolls. However, the workers accidentally mix Chucky's blood into a vat of plastic. Since the soul of serial killer Charles Lee Ray still inhabits the remains, the mixture causes Chucky to revive. Chucky is unwittingly given to Play Pals' CEO Mr. Sullivan, whom he kills with a variety of toys. He then uses computer records to locate Andy.
Meanwhile, 16-year-old Andy Barclay, still troubled by his past encounters with Chucky, has been sent to Kent Military Academy after failing to cope in several foster homes. Colonel Cochrane, the school's commandant, begrudgingly enrolls Andy but advises him to forget his "fantasies" about the doll. Andy befriends cadets Harold Aubrey Whitehurst, Ronald Tyler, and Kristin DeSilva, for whom he develops romantic feelings. He also meets Brett C. Shelton, a lieutenant colonel who routinely bullies the cadets.
Shortly after Andy arrives, Tyler is asked to deliver a package to his room. Tyler realizes that the package contains a Good Guys doll and, excited, takes it to the cellar to open it, only to have Chucky burst free from the package. Remembering the rule that he can possess the first person who learns his true nature and that he has a new body, Chucky tells Tyler his secret, but just as Chucky is about to possess him, they are interrupted by Cochrane, who takes the doll away. Cochrane 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. 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 unsuccessfully tries to warn Tyler about Chucky. At one point, Chucky lures Tyler into playing hide-and-seek in Cochrane's office, where he attempts to possess Tyler again. However, they are interrupted by DeSilva and, moments later, Cochrane himself. When the cadets leave, Cochrane is suddenly confronted by a knife-wielding Chucky. The resulting shock causes Cochrane to suffer a fatal heart attack. The next morning, Andy tries to convince Tyler that Chucky is evil, but Tyler refuses to believe him. Meanwhile, Chucky kills the camp barber Sergeant Botnick by slashing his throat with a razor after Botnick tries to shave Chucky's hair off.
Despite Cochrane's death, Sgt. Clark declares that the school's annual war games will proceed as planned, with Andy and Shelton on the same team. However, Chucky secretly replaces the blank paint bullets of the Red team with live ammunition. When the simulation begins, Chucky accosts Tyler. Finally realizing that Andy was telling the truth about Chucky, Tyler stabs Chucky with a pocket knife and flees to find Andy. Chucky then attacks Kristin and holds her hostage, attempting to lure the teams into fighting each other to save her. Chucky forces Andy to exchange Kristin for Tyler.
Suddenly, the Red team descends upon the area and obliviously opens fire with their live rounds, with Shelton being 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. With no time to mourn his friend, Andy heads off in pursuit of Chucky, with Kristin close behind.
Eventually, the chase leads the group into a fake haunted house at a nearby carnival. Tyler tries to get a security guard to help him, but Chucky kills the guard offscreen and kidnaps Tyler. In the ensuing melee, Chucky shoots Kristin in the leg, leaving Andy to fight Chucky alone. When Tyler is inadvertently knocked out, Chucky seizes the opportunity to possess him, but Andy intervenes, shooting him several times. Enraged, Chucky springs back and attempts to strangle demi but Andy uses Tyler's knife to cut off Chucky's hand, dropping the killer doll onto a giant fan which ultimately destroys him. Afterwards,demi is taken into custody by the police for questioning and Kristin is rushed to the hospital, leaving Tyler's fate unknown as the carnival shuts down.