In present-day Scotland, an American tourist couple go into a bar where they meet an old man who tells them a story about the Loch Ness Monster.
In 1942 Scotland, a boy named Angus MacMorrow lives in the large manor house of Lord Killin on the shores of Loch Ness with his mother Anne MacMorrow (the housekeeper), his sister, a cook, a maid and an old gamekeeper. Later, they are joined by Lewis Mowbray, who comes to work as a handyman in the manor. Angus' father Charlie —Killin's former handyman— is now a sailor in the Royal Navy and has been missing since his ship was sunk in the war 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 it in his father's shed. When he returns later, an unknown creature hatches (which he calls 'Crusoe' after Robinson Crusoe) that becomes the fabled Loch Ness Monster. Angus keeps the creature a secret, but eventually tells his sister and (reluctantly) Lewis about it. Lewis explains to Angus that it is a genderless "Water Horse" that lays one egg, then dies before it hatches.
The next day troops of the 12th Medium Regiment Royal Artillery arrive at the house, 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 defence against possible attacking or hiding German U-boats and the troops set up camp on the grounds of the house. An anti-submarine net is also raised at the mouth of the lake to prevent the possible entrance of German U-boats into the lake.
One night, when the men are invited into the house for dinner, Crusoe breaks free, and roams the house, running into the cook's bulldog "Churchill" which chases him into the dining room. Unnoticed, Churchill is blamed for the mess. Meanwhile, Crusoe spends the night in a fountain feeding on the fish, where the next day, Lewis finds he has grown so big that he and Angus have no choice but to let him roam wild in the loch.
Captain Hamilton proclaims Lewis to be a bad influence, and persuades Angus' mother to allow him to teach Angus some discipline and make a soldier out of him. However, after a few days, Angus escapes and returns to the lake, where Crusoe grown as an adult, encourages Angus to ride on its back. After some time, it begins to dive underwater, coming to the surface from time to time for breathing. Angus, having aquaphobia, protests diving, but later enjoys himself (finally overcoming his phobia of the sea). Umbenknownst to the pair, the cook learns of Crusoe's existence.
The English Captain takes the MacMorrow family to Loch Ness to impress Anne; Crusoe suffers from shock after almost getting hit by an exploding shot from a cannon ("Victoria") shot on the lake during a firing demonstration. Angus interrupts to save Crusoe from injury or death, enraging Hamilton when he defies orders by getting close to the artillery, upsetting his mother. Angus is confined to his room for a month as punishment for acting out for his apparent imaginary companion.
Two old fishermen who previously saw Crusoe, attempts 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 thanks to Victoria, 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.
Kirstie, Angus's sister lets him sneak out of his room and to the lake. Churchill, having caught Crusoe's scent at the shore where he reconciled with Angus, alerts the soldiers of its presence; Crusoe surfaces, only this time he has the advantage in size. The cook notices that the barking suddenly stops where it is presumed that Crusoe devoured Churchill or scared him off. The surprise attack proves futile for the soldiers, as Crusoe easily capsizes their boat. Angus attempts to calm Crusoe down and wades into the lake where he loses his footing and sinks. Crusoe comes to Angus' rescue and saves his life. When his mother arrives, she finally believes in her son when she sees Crusoe. However, new guns from the nearby artillery battery open fire upon Crusoe, mistaking it for a German U-Boat. Crusoe attempts to jump over the anti-submarine net but instead crushes it with its weight and escapes from the lake, which also causes all their guns to blow up again.
At sunrise with his mother, Angus finally accepts his father's fate as they watch Crusoe's departure from afar in the open sea. It is implied that Anne is also ready to move on, having fallen in love with Lewis, himself an honorably discharged veteran (whom Hamilton earlier accused of being a deserter or coward, considering himself a superior suitor and father figure).
Over the years, the rumor spread that Crusoe was returning in search of his friend Angus and several people claim to have seen Crusoe but Angus never saw him again.The tourists ask the old storyteller's name, which he reveals to be Angus MacMorrow. Outside the pub, a mother calls out her son, who is walking down the beach and spots a rock, which has an iridescent shell beneath just like Crusoe's, hinting that Crusoe has died, leaving a descendant behind to become the next Water Horse.