The opening of the story recaps events from the end of the previous film: Daniel LaRusso squares off against Johnny Lawrence in the final match of the All-Valley Under-18 Karate Tournament and wins the match and the tournament when he plants the Crane Kick to Johnny's chin. Following the match, Daniel is showering and changes back into street clothes, and suggests to Miyagi that they perhaps go on tour to different karate championships. Miyagi kindly says that Daniel should consider "early retirement". Daniel humbly agrees.
As they walk out to the parking lot, Daniel is congratulated by the tourney's announcer and referee on his win. Kreese, Johnny's sensei from Cobra Kai, stalks past, pushing people angrily out of his way. He finds his students in the lot and berates Johnny for not winning the tourney. The scene turns ugly when Johnny talks back. Kreese suddenly breaks Johnny's trophy, grabs Johnny in a headlock, and backhands Jimmy, another of his students, when he tries to intervene. Miyagi tells Daniel to wait by their truck and confronts Kreese, ordering him to let Johnny go. When he doesn't, Miyagi frees Johnny himself. Kreese furiously tries to punch Miyagi, who easily dodges the blow. Kreese's fist breaks a car window. When he tries to hit Miyagi again, he breaks another car window when Miyagi sidesteps again. With both of Kreese's hands bloodied, Miyagi forces him to his knees and prepares to deliver a seemingly deadly strike to Kreese, growling Kreese's own words about showing an enemy no mercy. He gives a huge yell...then stops short of landing the blow and instead honks Kreese's nose and drops him to the ground. Miyagi explains to Daniel that Kreese will have to live with the shame of being publicly humiliated, which is far worse than death.
Six months later, an angry Daniel arrives at Miyagi's house. The car that Miyagi gave him, a 1948 Ford Super De Luxe, is having mechanical trouble and Daniel, dressed in a tuxedo, is talking angrily about how badly his prom went: his girlfriend, Ali, had borrowed his car and had caused the mechanical trouble. Daniel also grouses about how Ali has found a new boyfriend. To make matters worse, Daniel tells Miyagi that his mother has accepted a temporary transfer to Fresno for the summer and Daniel will have to go with her. Miyagi quickly fixes Daniel's car and takes him to the back of his house where he seems to be constructing a new room. He persuades Daniel to calm down and focus with his breathing technique and shows Daniel how to drive nails with a single shot. Daniel soon feels better and asks Miyagi what the addition to the house is for. Miyagi tells Daniel that the room is for a "refugee" from Fresno — he'd talked to Daniel's mother, who'd agreed to let Daniel stay in Los Angeles with Miyagi for the summer.
A few minutes later, the mail carrier shows up and gives Miyagi an overseas letter. The letter is from Miyagi's former girlfriend in Okinawa. Miyagi's father is dying. Miyagi has to travel to Okinawa to see his father before he dies. Miyagi also tells Daniel more of the story about his leaving Okinawa: he'd fallen in love with a young woman named Yukie who was betrothed to his best friend, Sato Toguchi. Miyagi talks about how he was young and foolish and had told the entire village that he was going to marry Yukie despite her parents' wishes. Sato, whose karate teacher was also Miyagi's father, challenged his friend to a duel to the death. Miyagi chose to leave rather than fight his best friend.
When he's about to board his plane, Daniel suddenly shows up, having persuaded his mother to accompany Miyagi on the trip. Miyagi is reluctant and Daniel tells him he'd used his savings to buy the ticket. Miyagi agrees and they both fly to Okinawa. On the plane, Daniel studies a book on Okinawan history and is strangely unable to locate Miyagi's village on the map.
When they arrive, they are met by Sato's nephew Chozen, who has a car waiting for them. Before Daniel gets in the car, Chozen shakes hands with Daniel, menacingly crushing Daniel's hand. Chozen and his driver take the two to a warehouse near the airport. They are met by Sato, who still holds a grudge against Miyagi and reminds him of his actions years ago. Miyagi refuses to fight Sato. Sato and Chozen leave Miyagi and Daniel to find their own way to town.
In a taxi, they stop at the US Air Force base, which Miyagi remembers being the location of his village, called Tomi. An Air Force officer tells them that the village was moved years ago when the base expanded. Arriving at Tomi, Miyagi goes immediately to his father's house. He and Daniel are met by a young woman about Daniel's age, Kumiko, and Miyagi's former love, Yukie. Yukie is happy to see Miyagi and reveals that after Miyagi had left, she hadn't married Sato & hadn't ever married. Later, Miyagi's father requests that both his son and Sato see him. He joins their hands together, asking them to make peace between them right before he dies. Sato grants Miyagi three days to mourn before they fight.
Miyagi takes Daniel on a tour of Tomi. They arrive at the fishing house where Miyagi used to work. Miyagi shares a story about how he was distracted when a large net of fish came in and he was almost impaled on the net hook. To demonstrate, he releases one of the hooks and swivels at the hips and knees, just barely avoiding being killed. Miyagi calls it the "drum technique", which is reminiscent of the ceremonial drum of the local villagers. Daniel asks to try himself and is forced to jump off the pedestal and falls into the water. Miyagi announces an end to the lesson, however, Daniel tries again, releasing a hook on his own and successfully dodging it. Miyagi agrees with Daniel that it was a stupid thing to do.
Meanwhile, Daniel has run afoul of Chozen, who is intent on harassing Miyagi in his uncle's name. Daniel catches Chozen cheating the villagers for food with fake scale weights. Chozen also seems jealous of Daniel's budding relationship with Kumiko and harangues him often. When Kumiko sees Daniel practicing the "drum" technique he'd learned from Miyagi, she tells him it looks like an ancient Japanese dance called O-Bon. Chozen shows up, drunk, and teases Daniel. The confrontation turns violent and Chozen beats Daniel.
While on a date with Kumiko, they go into a bar full of locals and American servicemen who, despite their obvious ignorance of martial arts, are trying to karate chop thick sheets of ice for money. None of them have made it through more than two sheets. Daniel explains to Kumiko what they're doing wrong and one of the Americans drops a challenge. Chozen suddenly appears offering 3-to-1 odds that Daniel can't break six sheets. Miyagi steps in, having been found nearby by Kumiko, and takes Chozen's wager. Sato is there too and covers Chozen's bet. At Miyagi's suggestion, Daniel meditates for a few moments and easily breaks all six sheets. Miyagi gives Daniel his share of the money. Later that night, Daniel goes with Kumiko to a 1950s sock hop. Chozen is there and begins to beat on Daniel and takes the money he'd lost back. Daniel hits Chozen in the crotch and gets his money back, retreating with Kumiko.
Miyagi meets with Sato at Sato's house. There he finds Sato practicing on a large wooden plank. Miyagi knows the plank is the same one they found on the beach as friends. Miyagi appeals to Sato, saying he still doesn't want to fight his old friend. Sato scoffs and walks away. Miyagi also reconciles with Yukie, apologizing for leaving her. She tells him that she'd never married because of Miyagi's conflict with Sato. Daniel and Kumiko later see Miyagi and Yukie engaged in an ancient tea ceremony where they declare their love for each other.
When Miyagi's three days of mourning have passed, Sato and Chozen show up at Miyagi's home. When they are unable to find Miyagi, Sato leaves, telling his nephew to "leave a message" for him. Daniel is awoken by their voices and goes downstairs to the courtyard and is immediately grabbed by Chozen's friends. Chozen threatens Daniel with a spear, using it to get him in a chokehold while his friends tear up the courtyard garden. Miyagi appears and orders Chozen to let Daniel go. Miyagi then engages all three boys in a short fight, defeating them all, including Chozen who tries to use the spear. Miyagi wrests it away and stops short of stabbing Chozen with it, eventually breaking it in half. He takes Daniel into the house while the boys leave, telling his student they'll leave tomorrow.
The next day Sato has part of the local's gardens bulldozed. Miyagi confronts Sato again, telling him that he'll fight him on one condition: no matter who wins, the deed for the land the village sits on will be turned over to the residents forever. Sato scoffs but agrees when Miyagi tells him that it's a small price to pay.
Miyagi later talks to Daniel, telling him he's willed his estate in Los Angeles and all its contents to Daniel should he die in the fight. Miyagi goes off to prepare. Daniel passes by a small chapel where he sees Sato meditating. As he walks past, he sees Kumiko sitting alone in another house. When he joins her, he sees that she's prepared a tea ceremony for them both. When the ritual is complete, the two of them kiss.
Suddenly a tropical storm kicks up and they're forced to find shelter in an old concrete bunker left over from World War II. Miyagi is there already and he and Daniel see the chapel that Sato was meditating in suddenly collapse. They both run over to find Sato pinned under a thick beam. While Sato yells about Miyagi taking advantage of his helplessness, Miyagi strikes the beam, breaking it in half. They free Sato, who is thoroughly stunned at his quiet rival's sheer might, and take him to the shelter. Daniel breaks off from them to help the little girl who was on a small tower ringing the town's emergency bell. Daniel brings her down from her perch and struggles to reach the shelter. Sato orders Chozen to help Daniel, but he refuses, ashamed. Disgusted at his nephew's cowardice and impressed with Daniel's heroism, Sato runs out and helps Daniel out. When he makes it back to the shelter, he disowns Chozen. Chozen runs off into the storm.
The next day, as the villagers are cleaning up, Sato joins them and hands the deed to the land over to Miyagi. At this, Sato bows and begs for forgiveness, which Miyagi answers that there is nothing to forgive. Daniel approaches him and asks if they can hold an o-bon at the ruins of an old temple near the ocean. Sato agrees. The dance is held that night. One of the events has Kumiko performing a traditional solo dance.
Shortly after she begins, Chozen suddenly slides down on a lantern rope and grabs her, holding her hostage and challenging Daniel to fight him. Daniel accepts and crosses the small bridge, throwing it into the moat. The two fight, seemingly to a draw. Suddenly Miyagi and the other spectators begin using their small drums. Chozen is distracted and Daniel begins to hit him repeatedly, having learned the counterpunch of the technique. Chozen is beaten and Daniel tweeks his nose in the same manner that Miyagi used on Kreese. The film ends with Miyagi smiling and Daniel holding Kumiko.
