In present-day Scotland, an American tourist couple go into a bar where they meet an old man who, per their request (after the tourists see the surgeon's photo), tells them a story about the Loch Ness Monster and how the fake photo came about.
In 1942 during World War II, a boy named Angus MacMorrow lives in the manor house of Lord Killin on the shores of Loch Ness with his mother Anne MacMorrow and his sister, Kirstie. Later, they are joined by Lewis Mowbray, who comes to work as a handyman in the manor. Angus' father Charles —Killin's former handyman— is a sailor in the Royal Navy and has been missing since his ship was sunk in the war almost a year ago; Angus is unable to accept that it is unlikely he will ever come home.
One day, while collecting seashells, he discovers what appears to be a large mysterious egg in the sand, which he leaves in his father's shed. When he returns later, an unknown creature hatches, which he calls 'Crusoe' after Robinson Crusoe. Angus decides to keep the creature a secret, but eventually tells his sister and Lewis after they discover it. Lewis explains to Angus that it is a genderless "Water Horse" that lays one egg, then dies before it hatches.
Not long afterwards, troops of the 12th Medium Regiment Royal Artillery arrive at the house which is commanded by Captain Thomas Hamilton – a friend of Lord Killin, who is serving with the Royal Air Force. An artillery battery is set up near the lake as a defence against German U-boats while the troops set up camp on the manor grounds. Meanwhile, Lewis discovers Crusoe to have grown so big that he and Angus have no choice but to let it roam free in the loch.
Captain Hamilton proclaims Lewis to be a bad influence, and Angus' mother allows him to teach Angus some discipline and make a soldier out of him. However, after a few days of training, Angus escapes and returns to the lake, where Crusoe, now a full-grown adult, encourages Angus to ride on its back. After some time, it begins to dive underwater. Angus, having aquaphobia, protests diving, but later enjoys himself and finally overcomes his phobia.
The next day, Captain Hamilton takes the MacMorrow family to a hill overlooking Loch Ness; Crusoe is shocked after almost getting hit by an exploding artillery shell during a firing demonstration. Angus interrupts to save Crusoe from injury or death, but in the process, enrages Hamilton and irritates Angus' mother, who doesn't know what a Water Horse is and won't believe Angus when he tries to tell her. Angus is sent to his room at six every night for a month, as punishment for his inappropriate behavior on the hill.
Two fishermen who previously saw Crusoe, attempt to take a photo of the creature for fame and fortune. When they realize that they won't be able to photograph the real thing due to the bombardment, they decide to create an imitation. (The result is the real-life faked picture of The Loch Ness Monster known as "The Surgeon's Photo".) The photo piques the interest of a few soldiers, who venture out on the lake at night to hunt it with Sergeant Walker leading the hunt.
Angus, who sneaks out of his room with his sister's help, visits the lake and calls for Crusoe. Crusoe rises, still in shock and fear from the earlier bombardment, nearly bites off Angus's hand before sinking back into the loch. Hamilton's dog Churchill, having caught Crusoe's scent at the shore, alerts the soldiers of its presence. Crusoe then surprises the soldiers and capsizes their boat but not before one of the soldiers sends out an SOS to Hamilton, who thinks the Germans are attacking. Back at the loch, Angus attempts to calm Crusoe, who is attacking Strunk and wades into the lake where he loses his footing and sinks.
Crusoe comes to Angus's rescue and saves his life. When his mother arrives, she finally believes her son when she sees Crusoe, though does not notice the creature at first and accuses Lewis of filling Angus's head with tales of sea creatures and magic. The nearby artillery battery soon opens fire upon Crusoe, having mistaken it for a German U-Boat. Angus, Hamilton, Anne and Lewis lead Crusoe to safety at the net, who escapes into the sea.
At sunrise, Angus finally accepts his father's fate before they watch Crusoe's departure. It is implied that Anne is also ready to move on, having fallen in love with Lewis. Over the years after Crusoe's departure, several people claim to have seen it but Angus never sees Crusoe again while others said that Crusoe returned in search of Angus and could see it. The tourists thank the old storyteller and ask for his name, which he reveals to be Angus Macmorrow. Outside the pub, a mother calls out to her son William, who is walking down the beach. He spots a rock, which has an iridescent shell just like Crusoe's, hinting that Crusoe has died and has left a descendant behind to become the next Water Horse.
Alex Etel as Angus MacMorrow
Brian Cox as Older Angus MacMorrow
Louis Owen Collins as young Angus MacMorrow
Emily Watson as Anne MacMorrow
Ben Chaplin as Lewis Mowbray
David Morrissey as Captain Thomas Hamilton
Priyanka Xi as Kirstie MacMorrow
Marshall Napier as Sgt. Strunk
Joel Tobeck as Sgt. Walker
Erroll Shand as Lt. Wormsley
Craig Hall as Charles MacMorrow
Geraldine Brophy as Gracie
stylised on-screen as simply The Water Horse
based on Dick King-Smith's children's novel The Water Horse