Will Atenten returns home to his wife and daughters. His wife is increasingly uneasy due to a series of events, including their daughters seeing a strange man outside their home.
Will tries to enlist the help of the local police but they appear strangely unwilling to assist. He also approaches one of his neighbours who seems apprehensive. He decides to conduct his own investigations and in doing so finds out that he is a mental patient who recently left a psychiatric hospital and then a halfway house and his real name is Peter Ward. Five years earlier, his wife, Libby, (Rachel Weisz) and daughters Trish and Dee Dee were murdered at their home. During the attack, Peter was shot in the head, and so he has no memories of the murders. Instead, he has created a fantasy world in which his wife and daughters are fine. He created a new identity for himself in order to cope with the grief of his family's death. In his fantasy, he is a successful book publisher named Will Atenten based on his inpatient ID band W1ll 8-10-10.Peter moves back to his abandoned old house and lives inside. It is boarded up and unsafe and covered with graffiti, but in Peter's disturbed mind, the house is gorgeous and his wife and kids live there happily.
The audience learns that everything that has occurred up to this point in the movie was just fantasy. He is informed by the doctors that he claimed he was innocent. He returns to his house, which is actually abandoned and decrepit, and converses with the projections of his wife and daughters, who claim that they believe in his innocence.
His neighbour Ann (Naomi Watts), reaches out to him. Ann believes in his innocence and encourages Peter to live a new life in order to heal himself. Peter eventually decides to return to his old house to confront his memories and, with Ann's help and support, realizes that he did not kill his family. It was a local man named Boyce (Elias Koteas), who broke into the house and shot Peter's family.
Peter and Ann are suddenly attacked by Boyce and Ann's ex, Jack, who reveals that he had hired Boyce to kill Ann so he could get revenge against her for divorcing him. Boyce got into the wrong house and accidentally killed Peter's family. Jack decides to kill Ann and set the house on fire, framing Peter for her murder, and shoots Boyce as punishment for his early failure. As they try to ignite a fire, Peter escapes, overpowers Jack and saves Ann. Boyce douses Jack in gasoline in revenge for being shot, but Jack shoots him in the head before being consumed by the flames.
While Ann and Chloe reunite, Peter confronts the ghosts of his wife and children, who forgive him and say goodbye. Peter escapes, having finally discovered the truth and gained inner peace.
One year later, Peter has returned to New York City and published a book called "Dream House," using his real name, Peter Ward, about his recent experiences.
