Set in 1905 (the year the Little Nemo comic strip premiered in the New York Herald), the film opens with the young boy Nemo experiencing a nightmare in which he is pursued by a locomotive. Upon awakening the next day, he, along with Hubie, Marina, Rocko, Petra, Beanie, Timmy Pikatwo, Bonkers, Fawn and Pikatwo go to see a parade welcoming a traveling circus. However, Nemo is unable to see the circus because his father and his mother are too busy to take him. Later that night, Nemo imitates sleepwalking in an attempt to sneak some pie away, which acts against a promise he had made earlier to his mother. Upon falling asleep that night, Nemo, Hubie and their friends are approached by figures from the parade. The circus organist introduces himself as Professor Genius and claims that they had been sent on a mission by King Morpheus, the king of a realm named Slumberland. The mission involves Nemo becoming the playmate of the princess, Camille. Although Nemo initially has reservations about interacting with royalty of the opposite gender, he decides to set off to fulfill his mission, but not before asking Hubie and his friends to join.

Nemo, Hubie and their friends are taken to Slumberland in a dirigible which Nemo is allowed to drive, causing some chaos and are introduced to King Morpheus, who doubles as the circus ringmaster in Earth. Morpheus reveals that he summoned Nemo to become his heir to the throne. Morpheus gives Nemo a golden key and warns him of a door with a dragon insignia that must never be opened. Nemo, Hubie and their friends are introduced to Princess Camille and they roam the entirety of Slumberland together. Afterwards, Nemo is seperated from Hubie and his friends after he meets the mischievous clown, Flip, who angers a group of cops and forces him and Nemo to hide out in an underground cave. There, Nemo discovers the door that Morpheus warned him not to open. Flip tempts Nemo into unlocking the door, which unleashes the dreaded Nightmare King. Nemo rushes back to Morpheus' castle in time for his coronation ceremony, where Nemo is handed the royal scepter, the only thing capable of defeating the Nightmare King should he ever return to Slumberland. In the middle of a dance session between Morpheus and Genius, the Nightmare King reaches the castle and steals Morpheus away. As the partygoers search for a scapegoat, Flip reveals that Nemo was responsible for the Nightmare King's escape, since Morpheus gave him the key.

Nemo awakens in his home, which floods with seawater and ejects him along with Hubie, Marina and their friends into the ocean. Genius discovers them and tells Nemo not to blame himself for all that has happened. When the group returns to Slumberland, Flip reveals that he has a map to Nightmare Land, where Morpheus is currently being held. Nemo, Camille, Flip, Genius, Hubie and his friends set off in a tugboat in search of Morpheus. They are soon sucked into a whirlpool and find themselves in the monster-infested Nightmare Land. The group come across a group of shapeshifting goblins who wish to aid in the quest to find Morpheus. The Nightmare King sends a flock of giant bats to seize the rescue party. Nemo attempts to use the scepter, but awakens in his bed instead. The goblins appear in Nemo's room and the group travels to Nightmare Castle by flying through a hole in the sky. However, they are subsequently imprisoned in the castle, where the Nightmare King demands possession of the scepter. Nemo soon uses the scepter to finally eliminate and defeat the Nightmare King. Slumberland celebrates the fall of the Nightmare Kingdom. Camille escorts Nemo, Hubie and their friends home on dirigible. Nemo and Camille share a kiss after which Nemo awakens in his room, along with Hubie and his friends. Nemo apologizes to his mother for breaking his promise and trying to take the pie. Nemo's parents also agree to take Nemo to the circus. Nemo, Hubie, Marina and their friends stare out the window as they reflects on their adventure.