During the London Blitz of World War II, Peter Pan's former playmate, Wendy Darling, has grown up and married, and has two children of her own: an 12-year-old daughter, Jane, and a 4-year-old son, Danny. Her husband, Edward, is sent to fight in the war, leaving her to raise the children by herself. She tries to keep their spirits up with stories of Peter Pan, but Jane has become cynical under the pressures of the war, belittling the stories her mother tells and unintentionally ridiculing her brother's faith in them.
Captain Hook, still seeking revenge against Peter Pan, sails through the skies on his pixie-dust-enchanted pirate ship, finds Jane sleeping by the window, and, mistaking her for Wendy, flies back to Neverland with her, to use as bait for Peter. However, his ship triggers an alarm and is mistaken for a Luftwaffe bomber, forcing Hook to escape for his life as the Germans attack London. Back in Never Land, he drops Jane into the waiting tentacles of "the beast" (a giant octopus), expecting Peter to also be devoured by it as he dives after "Wendy" to save her, along with Tinker Bell who has gotten rid of her jealousy of Wendy; however, Peter rescues Jane, and Hook is eaten instead. Though Hook manages to escape, the octopus enjoys his taste (much like Tick-Tock the Crocodile, whom he had finally managed to get rid of long before), and begins hunting him down.
Peter rescues Jane, and, upon finding she is Wendy's daughter, assumes she would like to follow in her mother's footsteps. He takes her to his home to be mother to the Lost Boys, but Jane refuses, because she is more interested in getting back home (so she can try to make amends for her cold behavior towards her brother). They try to make her have fun and to teach her to fly, but she fails because she does not believe, so Peter tries to use Tinker Bell's jealousy of Jane to help. Tink showers Jane in pixie dust, but still Jane cannot fly. Peter and the Lost Boys discover a note book of Jane's and tease her by playing Keep Away until Cubby accidentally swallows it. As the boys burst out laughing, Jane becomes angry and blurts out that she is fed up with their childish behavior. In her anger, she also says that she does not believe in fairies, which leaves Tinker Bell slowly dying. Peter tells the Lost Boys that if Jane doesn't believe, "Tink's light's gonna go out". Peter tells the boys they have to make her a part of the group but the Lost Boys complained because she is a girl but Peter convinced them to allow it for Tinkerbell's sake.
After Jane leaves them, she is approached by Hook, who tricks her with a deal. He promises to take her home and lies that he will not harm Peter, and she agrees to help him find his treasure which Peter Pan stole. He gives Jane a whistle to signal him when she locates it. The Lost Boys search for Jane and eventually Peter finds her. He apologizes for her book getting ruined and says he wants to make it up to her, so Jane suggests they play a game of "treasure hunt". Peter and the Lost Boys show her how they have fun and she begins to change her serious image and learns to have fun too. When Jane finds the treasure, she takes the whistle Hook gave her and throws it away, refusing to help him. Peter and the Lost Boys make Jane the very first Lost Girl to which she is very moved by and they celebrate. However, one of the Lost Boys finds the whistle and, not realizing what it is for, blows it. Hook and his crew arrive, and captures Peter Pan and the Lost Boys, but let Jane go as thanks for "helping" them. Despite Jane denying she wanted to help Hook in this way, Peter calls her a traitor and tells her that because she does not believe in fairies Tinker Bell is dying.
Jane rushes to the Lost Boys' home, but gets to Tinker Bell too late. Jane breaks down into tears realizing it is her fault Tinker Bell is gone and that Peter and the Lost Boys have been captured. Jane's new-found belief, however, revives Tinker Bell at the last minute. They both hurry to the Jolly Roger, where they find the Lost Boys tied up and Peter (tied to an anchor) about to walk the plank. Jane saves him, and with the help of "faith, trust, and pixie dust", she learns to fly and unties Peter, once again renewing their friendship. Hook grabs Jane, but Peter manages to save her. Suddenly, the octopus shows up and sinks the ship. Hook and the pirates exit via a rowboat, pursued by the octopus, who makes a "blip-bloop" sound with his tentacles (similar to the crocodile's ticking) as he chases them.
Now that she can fly, Jane is able to return home to Wendy and Danny. After a tear-filled farewell to the Lost Boys, Peter and Tinker Bell escort her home, with the Lost Boys joining them for their trip. While Jane reconciles with Danny, Wendy and Peter meet again, for the first time in years. Though Peter is disappointed that she has grown up, Wendy assures him that she has not really changed. Edward returns from the army and the family is reunited. Peter Pan and Tinker Bell watch for a few seconds before they quietly fly home.