In the early 20th century, in the quaint yet harsh landscape of Maine, young Pete, portrayed by Sean Marshall, is desperately escaping from his cruel adoptive family, the Gogans. They have subjected him to a life of servitude which he can no longer bear. The family's matriarch, Lena Gogan, played by Shelley Winters, along with the rest of the clan, seeks to entice Pete back to their oppressive home with the promise of "The Happiest Home in These Hills." However, an unseen friend, a whimsical dragon named Elliott, disrupts their attempts, creating chaos by sending Willie and the rest of the family tumbling into mud, diverting attention and creating a perfect opportunity for Pete to escape. Frustration mounts for the Gogans, who, having exhausted their funds "buying" Pete, realize that they cannot simply adopt another child in quick succession.
By the next morning, a serene moment unfolds as Pete and Elliott—revealed to be a large green and purple dragon—enjoy a delicious breakfast in a picturesque apple orchard, all while serenading each other with the joyful tune "Boo Bop BopBop Bop (I Love You, Too)." Polluting their adventurous spirits, they resolve to venture into the nearby fishing village of Passamaquoddy. However, Elliott's clumsiness soon becomes apparent; his antics attract attention, causing disturbances that mark Pete as a harbinger of ill fortune. Thus, he finds himself ostracized and compelled to escape once again. In a chance encounter with Lampie, a local tavern keeper played by Mickey Rooney, the gentle chaos continues as Elliott becomes visible and frightens the unsteady Lampie, who rushes back to the tavern to alert the townsfolk, but is dismissed as merely drunk, spouting nonsense about a dragon.
Enter Nora, expertly brought to life by Helen Reddy, Lampie's determined daughter, who searches for her father and unwittingly gets embroiled in the tavern's mockery of his supposed hallucinations. When she brings Lampie back to their lighthouse home, she spots Pete wandering along the beach and feels compelled to discover more about this strange boy. In a secluded cave near the lighthouse, Pete chastises Elliott for his troublemaking and reflects on his uncertain future. Their heartfelt reconciliation occurs before Nora stumbles upon them, leading to an invitation for Pete to stay the night at the lighthouse. During their bonding session, Pete shares his tumultuous backstory and how Elliott heroically saved him from the Gogans' clutches, singing "It's Not Easy," while Nora shows him a photo of her missing fiancé, Paul. Misinterpreting Elliott as a tool for Pete's comfort, she indulges in his fantasies, believing that perhaps this imaginary friend will help them both cope with their realities.
The plot thickens as Doc Terminus, a slick snake-oil salesman portrayed by Jim Dale, accompanied by his bumbling assistant Hoagie, arrives in Passamaquoddy, stirring significant unease among the locals. Initially met with hostility due to his previous schemes, Terminus charmingly soothes the townspeople with his sales patter, launching himself back into their good graces with the flamboyant song "Passamashloddy." Meanwhile, Nora looks after Pete, even shopping for him to ensure he fits in. That evening, his curiosity piqued, Pete wishes to show Elliott his new suit, and they decide to visit the cave again, although Lampie's warnings about keeping Elliott from the lighthouse loom large in their minds. A tender moment is spotlighted as Nora muses about holding onto hope for her fiancé's return, while Lampie bluntly communicates that he questions the plausibility of Pete's dragon.
Nora takes Pete to school, where an unexpected shift occurs as the local fishermen blame him for an unfortunate drop in fish stocks. Despite this, she fiercely defends Pete and assures everyone that there’s always “Room For Everyone.” At school, chaos ensues when Elliott, ever the mischief-maker, rings the school bell, leading Miss Taylor to mistakenly punish Pete, further enraging his dragon companion. Enraged by the injustice, Elliott retaliates, making an indelible mark by leaving dragon-shaped holes in the walls, causing Terminus to realize the reality of the dragon—his plot to capture Elliott now formulating.
Following encounters escalate as Terminus makes a dubious offer to Pete for the dragon, one that the brave boy shockingly refutes because he regards Elliott as family rather than property. As the plot thickens, the Gogans arrive in town, still obsessively in search of Pete. Tensions rise, but Elliott swoops in just in time, disrupting their plans and thwarting their sinister intents while simultaneously helping Pete find himself a caring and stable new family, anchored by Nora and Lampie's desire to adopt him, expressed in the heartwarming song "Brazzle Dazzle Day."
As the climax approaches, a brewing storm signals chaos. However, the salvation comes when Elliott reveals he knows the whereabouts of Paul, leading to an emotional upsurge as the community braces for disruption. Terminus, hungry for control over the dragon, devises a cunning trap. In a thrilling sequence of events, Elliott manages to save Pete and the rest of the town from the clutches of danger, leading to heroic feats, chaotic misunderstandings, and ultimately the acceptance of the dragon by the townsfolk after he saves a ship from perilous disaster.
With the smoke of confrontation lifted, Elliott, having fulfilled his duty of protecting Pete and guiding him toward a brighter future, must now sadly bid farewell. With heartfelt emotions, the two friends part ways, solidified in their bond yet destined for separate paths, as Elliott gracefully takes flight into the unknown. With Paul finally returning to Nora, the community finds hope, camaraderie, and renewed purpose, culminating in the poignant reprise of the sentiment that there truly is a dragon, a testament to the adventures they shared.
