The malevolent ghost that attacked the Freeling family in the first film, dubbed the Beast, is discovered to be the Reverend Henry Kane (Julian Beck), a preacher and medium that led his religious sect to California in the early 1800s to start a utopian society, but they disappeared near Questa Verde, believed to have all been killed by Indians. Diane (JoBeth Williams), who turns out to be clairvoyant like her mother Jess (Geraldine Fitzgerald) and Carol Anne (Heather O'Rourke), figures out through her clairvoyance, on Tangina's (Zelda Rubenstein) encouragement, the fate that befell them all.
It turns out Kane, who was power hungry and wanted to control the souls of his followers in life and in death, told his followers the end of the world was coming, so they all put themselves into an underground cavern with him. The day he predicted for the world's end came and went, but Kane refused to allow his followers to leave, so they all perished. Kane became the Beast, and he absorbed the spirits of his followers into him. The cavern lay directly beneath the graveyard the Freeling's house was built over. His ghost had been trying to possess Carol Anne because his followers became restless after tasting the light that was Carol Anne's life force, and mistaking her for the light that was the afterlife, they wanted her back because they felt like the first film, they could use her to go into the afterlife, and Kane didn't want his followers to do that. He seeks to take Carol Anne back to continue to confuse his followers and not let them move on into the light. He had never been able to get to her in Jess' house before she died, as her powerful life force protected the family, but her death paved the way for Kane to try and get Carol Anne again.
Steve (Craig T. Nelson) is told by Taylor (Will Sampson) to go back to Questa Verde with the family to where their house once stood to face Kane on his own turf. He and the family go to the cave with Tangina and enter the area where the skeletal remains of Kane and his followers are. Upon looking at Kane's remains, Diane and Carol Anne are brought into the Other Side, the dimension between the living world and the afterlife. Steve, Robbie (Oliver Robins), and Tangina head back to the entrance when they hear Taylor chanting, and find Taylor there who tells Steve & Robbie to enter the fire he built to go to the Other Side, and so they do, and reunite with Diane & Carol Anne. Kane attacks them, separating Carol Anne from the group and threatening to finally take her, but Taylor sends Steve his charmed lance, which Steve uses to stab Kane and send him packing while also freeing the souls of his followers from him. However, Carol Anne is sent flying, and the souls cling to her as she accidentally enters the afterlife. When everyone thought Carol Anne was lost forever, the spirit of Jess brings her back to her family, and they all return to the living world to a relieved Tangina & Taylor.
When they return to the surface, Taylor asks Steve if he could have their car so it could truly be happy, and Steve hands it over without any problems. As Taylor drives away, the Freelings realize that they can't get home without it, so they all make a mad dash for the car.
Thanks Tornado Dragon!