In southern California in 1984, 16-year-old high school student Todd Bowden (Brad Renfro) discovers that his elderly neighbor, Arthur Denker (Ian McKellen), is really Kurt Dussander a former Nazi Obersturmbannführer who is now a fugitive war criminal. Though Bowden threatens to turn Dussander in, the teenager reveals his fascination with Nazi activities during World War II and blackmails the war criminal into sharing stories about the death camps.
When he spends more time with the old man, his grades suffer, he loses interest in his girlfriend (Heather McComb), and he conceals his bad grades from his parents. In turn, the Nazi blackmails the young boy into studying to restore his grades, threatening to expose the boy's subterfuge and his dalliance with Nazism to his parents. Dussander even poses as Todd's grandfather and goes to an appointment with Bowden's school counselor Edward French (Ed Schwimmer). Talking about the war crimes affects both the old man and the young boy, and Dussander begins killing animals in his gas oven. Dussander also takes great pride in Bowden's unbelievable turnaround, going from near dropout to straight A's in a matter of weeks.
One night, Dussander tries to kill a hobo who sees him in the uniform. When Dussander has a heart attack, he calls Bowden, who finishes the job, cleans up, and calls an ambulance for Dussander. At the hospital, Dussander is recognized by a death camp survivor sharing his room, and he is arrested to be extradited to Israel. Bowden graduates as his school's valedictorian and gives a speech about Icarus, saying, "All great achievements arose from dissatisfaction. It is the desire to do better, to dig deeper, that propels civilization to greatness." The scene is juxtaposed in a montage with Dussander's home being searched and the hobo's corpse being found in the basement.
Bowden is briefly questioned about his relationship with Dussander, but he manages to convince the police that he knew nothing of the old man's true identity. At the hospital, Dussander hears a group of Neo-Nazis outside the hospital; realizing his identity has been hopelessly compromised, he commits suicide by giving himself an air embolism.
In the final scene, Mr. French learns that the old man who met him on that day was not Bowden's grandfather but a war criminal and confronts him over it. Bowden blackmails French into silence by threatening to accuse him of making inappropriate sexual advances towards him. As Dussander lays dead in his hospital bed, Todd Bowden graduates from high school now a full-blossomed sociopath due to his dalliance with Kurt Dussander.