In his Baltimore townhouse, famous local psychiatrist Dr. Hannibal Lecter (Anthony Hopkins) hosts a dinner party. The main subject of conversation over dinner is the disappearance of a local musician, who was criticized for playing several wrong notes at a concert that Lecter attended. He then serves the guests a delicious meal. When asked what the meat was that he served he says. "If I tell you, I'm afraid you won't even try it."
After dinner, Lecter is visited by Will Graham (Edward Norton), a young gifted FBI agent, with whom he has been working on a psychological profile of a local serial killer. Edible body parts of the victims, such as the kidneys and liver, were removed from the bodies after being killed, and Graham is convinced that the killer is actually a cannibal.
During the consultation and brainstorming session, Graham discovers evidence implicating Dr. Lecter in the murders. Shortly after that, Lecter returns and attacks Graham, wounding and nearly killing him, before Graham is able to subdue him.
Lecter is subsequently sentenced to life imprisonment at an institution for the criminally insane, while Graham retires from the FBI, having been severely traumatized by the experience.
Years later, another serial killer appears on the scene. Nicknamed the Tooth Fairy, he stalks and murders seemingly random families during sequential full moons.
Hoping to speed things up, and capture the killer before his next attack, Special Agent Jack Crawford seeks out Graham and pleads for his assistance. Graham, believing the death of another family to be an unbearable burden on his conscience, reluctantly agrees. After checking over the crime scenes, with only minimal insight, he comes to the realization that most of his previous successes were achieved due to the insightful collaborations of Dr. Lecter, and concludes that he must once again visit Lecter and seek his help in capturing the Tooth Fairy.
The Tooth Fairy is actually a disturbed man named Francis Dolarhyde (Ralph Fiennes), who suffers from schizophrenia and worshiped Lecter, after learning of his crimes. Calling himself "The Great Red Dragon" (because of his obsession with the William Blake painting, "The Great Red Dragon and the Woman Clothed in Sun"), Dolarhyde is unable to control his violent and sexual urges, which turn him into a dangerous serial killer. These conditions were born from the systematic child abuse he suffered at the hands of his grandmother.
Graham continues to run into complications, the first being Freddy Lounds (Philip Seymour Hoffman), a reporter for the tabloid, Tattler, whom Graham despises from the days following the conviction of Dr. Lecter, and who now follows Graham relentlessly for leads on the Tooth Fairy story.
Further complicating the investigation is the secret correspondence between Lecter and Dolarhyde. Lecter provides Dolarhyde with Graham's home address, which endangers Graham's wife, Molly (Mary-Louise Parker), and son Josh (Tyler Patrick Jones). Molly and Josh are evacuated to a remote farm, which belongs to Crawford's brother.
Graham discovers the secret communication, and tries to intercept it without Lecter's knowledge, but the doctor is quick to realize that the Feds are onto him and his protegé, and humiliates the authorities by upping the stakes: in return for his help in capturing the Tooth Fairy, he requests a first-class meal in his cell and having his book privileges returned.
Hoping to lure Dolarhyde into a trap, Graham gives Lounds an interview in which he gives disparaging details about what the FBI believes the killer to be: impotent and pathetic, whereas in fact they consider him cunning and highly dangerous. This provokes Dolarhyde, but instead of going immediately after Graham, he kidnaps and tortures Lounds, forcing him to recant his allegations on a taped recording. Dolarhyde then attacks and bites off the tip of Lounds' tongue before putting him in a wheelchair, setting him on fire and pushing the chair down the street where it comes to rest outside the Tattler's offices.
At about the same time, Dolarhyde falls in love with a blind co-worker at the video processing business they work at. Her name is Reba McClane (Emily Watson). Dolarhyde is very shy and tentative around Reba, but she senses his attraction to her and she is likewise attracted to him. Dolarhyde takes Reba to his large old home in the woods and they spend the night together. In the morning, Dolarhyde wakes to find Reba gone from the bed and he rushes around, frantic to find her. She was outside in the garden, but he was concerned she may have been snooping in the room where he kept his diary and a poster of the Red Dragon.
Dolarhyde's new-found love conflicts with his homicidal urges, which manifest themselves in his mind as "The Great Red Dragon". He senses that the Red Dragon wants the woman, and Dolarhyde vigorously resists the demand. He becomes so upset, that he grabs a sawed-off shotgun and places it in his mouth, preferring to kill himself rather than turning over Reba to the Red Dragon (by murdering and "changing" her).
After taking Reba to her home, Dolarhyde attempts to stop the Dragon's "possession" of him. He believes that he must dominate the dragon by consuming the original watercolor painting, so he goes to the Brooklyn Museum, asks to see the painting, then knocks out the female employee who took him to a back room to see the painting. He immediately shreds the painting and starts shoving it into his mouth, eating it. Another female employee comes into the room and Dolarhyde attacks her. He doesn't kill either woman, but he escapes.
Graham eventually realizes that the killer knew the layout of his victims' houses from their home videos, which the killer could only have seen if he worked for the home video editing company that transfers home movies to video cassette. Crawford and Graham go to the business and interview the manager. After describing the person they are looking for (the museum employees had provided a description), the manager recognizes the person as Dolarhyde. The manager tells Graham and Crawford that Dolarhyde's job gave him access to all home movies that passed through the company.
Dolarhyde just happened to be coming into the office at about that time, sees Graham, turns around and hurries out. He knows they are getting close to finding him. He decides to go see Reba one last time, but he finds her saying goodnight to another co-worker of theirs, Ralph Mandy (Frank Whaley). Ralph had been encouraging Reba to stay away from Dolarhyde and start going out with him. Dolarhyde watches as Ralph leans forward to kiss Reba goodnight.
Enraged, Dolarhyde wastes no time in shooting and killing Ralph, as he is walking down the walk from Reba's house. Dolarhyde then goes to the door and accosts Reba, placing a cloth with chloroform over her mouth, rendering her unconscious. He takes her to his house and brings her back to consciousness. He's upset at her for betraying him and tells her that he's going to shoot her, and then himself so that the Red Dragon can't have her. She begs him to let her go, or to run and take her with him.
Dolarhyde spreads gasoline around and sets it ablaze. He takes the shotgun and points it at Reba. But, when he realizes he can't do it, he repositions the gun and pulls the trigger. Blood spatters all over Reba's face and she screams. She crawls forward and puts her hand on the open wound of the body, then begins trying to find a way out of the house.
Crawford, Graham and many other police officers come roaring up to the house and meet Reba walking towards them. She tells them what happened, and as Graham attempts to go into the house, it explodes in a huge fireball.
Graham is given Dolarhyde's diary/scrapbook, which was in a steel safe and thus spared from the flames. The book details the killer's tragic childhood and obsessions with murder. Despite himself, Graham feels pity for Dolarhyde, who he realizes was made a monster, not born one.
Word comes back from the forensic pathologist that the body from the Dolarhyde house was not that of Francis Dolarhyde. It was actually Ralph Mandy, who had been on a week's vacation, therefore no one had missed him. That meant that Dolarhyde was still alive.
Crawford wasted no time in calling Graham, at his home with his wife and son, relaxing. Graham had just entered his house, looking for Josh to get him to come outside and sit with his parents. Graham notices almost immediately that the mirror in the entry area had been broken. He hears Crawford leaving a message on the phone, informing him that Dolarhyde is not dead. Graham wastes no time in going to the kitchen and arming himself with two sharp knives. He puts one under his belt in back and holds the other at the ready. He goes upstairs as quietly as possible, seeing more broken mirrors.
As Graham slowly pushes open the door to Josh's bedroom, he sees his son standing there, with Dolaryhyde holding one arm around Josh and his other hand holding a piece of broken mirror pressed against Josh's skin, near his right eye.
Amazingly calm and clear thinking, Graham decides to chastise Josh, telling him how disappointed he was with him, how rude Josh was being, and how he should apologize. That obviously was not what Dolarhyde expected to hear, and he becomes confused. Graham continues talking, transitioning his criticisms into those that Dolarhyde had endured from his grandmother, during his childhood.
Dolarhyde is infuriated and flings Josh to the side and attacks Graham. They struggle and during the fight, Dolarhyde slashes Graham across his abdomen. Graham then pulls the knife from his belt and jams it into Dolarhyde's left thigh. Graham runs and ushers his son into the master bedroom, locking the door. Graham tells Josh to hide under the bed and then goes to his closet and retrieves a handgun, readying it to fire when Dolarhyde finishes crashing through the door. However, Dolarhyde stops trying to break in.
Graham edges forward and looks under the door. He hears his wife calling out and watches as she appears at the top of the stairs. As she makes her way down the hallway, he sees Dolarhyde step out behind her. He shouts at Molly to get down, which she does, and Graham begins firing his pistol through the door. Dolarhyde also has a pistol and returns fire. They hit each other several times and both go down.
Molly pushes through the broken wood of the door and unlocks it, rushing to Graham's side, as he lay gasping for breath with blood bubbling from his mouth. Graham says to Molly, "shoot him." Molly turns to see Dolarhyde struggling to sit up. She hurriedly grabs Graham's pistol off the floor, steps forward into the hall, and, just as Dolarhyde is bringing his gun back up, she puts a shot right through his forehead, then another in his cheek. She rushes back into the bedroom to comfort Josh.
After recovering, Graham receives a letter from Dr. Lecter, which bids him well and hopes that he isn't too "disfigured" by his encounters with Dolarhyde and himself. Graham reads the letter while he's out on his sailboat. He crumples the letter up and throws it away.
Dr. Frederick Chilton informs Lecter that there is a young woman from the FBI waiting to speak with him. Lecter thinks for a minute, looks up, and asks what her name is.