The setting of the game is Phantomile, which is fueled by dreams people have at nighttime. Klonoa, an anthropomorphic animal who lives there, dreams about an airship crashing into Bell Hill, which eventually does happen the next day. Klonoa, along with his friend, a "ring spirit" named Huepow, investigate the site. Once there, they find a dark spirit named Ghadius along with his henchman Joka on the mountain who are seeking a magical moon pendant to turn Phantomile into a world of nightmares, kidnapping the diva Lephise to prevent her from renewing the world with the "Song of Rebirth". Eventually, Klonoa finds the pendant under a bell and returns home to Breezegale, where his caretaker Grandpa tells him that Granny, the chieftess of Forlock Forest, knows about the pendant, and the pendant is left behind.
Klonoa and Huepow venture out to find Granny, but are forced to take a detour to the kingdom of Jugpot in order to stop the water from flowing backwards, done by Ghadius to destroy the forest. The pair succeed in rescuing Granny from Joka, and Granny tells them a legend about the pendant, the legendary moon kingdom, Ghadius, and "the dream that creates this world". When Granny asks where the pendant is being kept, Klonoa tells her that Grandpa has it. Joka, eavesdropping on the conversation, heads off to steal the pendant before Klonoa can come back, bombing his home in the process and mortally wounding Grandpa before taking the pendant. Klonoa arrives too late and Grandpa soon dies in Klonoa's arms, but not before telling him to take the pendant back as it is his destiny. Klonoa is distraught over Grandpa's loss, but Huepow reminds him about the importance of their mission.
Klonoa and Huepow find help from Pamela, a flying fish, who takes them to the Temple of the Sun where they confront Ghadius and Joka. Ghadius reveals that the reason why he wants to turn Phantomile into a world of nightmares is because he wants revenge for being banished. Ghadius disappears and Klonoa faces Joka, eventually defeating him and avenging Grandpa. Soon after, the moon kingdom, Cress, appears, and Klonoa and Huepow head there with help from Pamela. Once there, Huepow reveals himself to be the prince of the moon kingdom, with his ring spirit form being merely a disguise. Klonoa decides to continue to help Huepow and eventually the pair finally do battle against Ghadius, defeating him, but not before Nahatomb is unleashed in Ghadius's death throes. Klonoa and Huepow defeat Nahatomb and rescue Laphise, who is thankful of them both.
Sometime later, Huepow tells Klonoa the truth: he was never from Phantomile and all his memories were fake. Klonoa thinks of it as a lie but Huepow reaffirms him that it's the truth. He also mentions that when Laphise sings the Song of Rebirth, Klonoa will not be able to stay in Phantomile any longer. Laphise eventually beings to sing, and a vortex opens, sucking Klonoa back to his homeworld. Despite the fabricated memories, the bond Klonoa shared with Huepow felt real to him and he refused to leave, Klonoa desperately clung onto Huepow with the Wind Ring, but is eventually sucked out. As a result, the vortex closes, and Phantomile is returned to its normal state.
