Plot
While in flight, the TARDIS and Rose dream of a fisherman who is attacked by a creature from the sea. Also appearing in the dream is an 'observer': a young boy. Tracing the source, the Doctor takes them to Ynys Du, a small village on the Welsh coast. They discover that the villagers are terrorised by fantastical monsters which roam the streets and woods at night; the adults are anxious and the children all have nightmares.
The trouble seems to have begun when an elderly Nathaniel Morton returned to the village after many years away and established a 'nursing home' in the old rectory. Here, six ancient figures sleep, attached to machines and attended by masked technicians.
The Doctor knows something is wrong, as the monsters do not appear to be the product of a normal evolutionary process. He traces an interference signal to the abandoned lighthouse on Black Island. Exploring the island with an eccentric local woman, Bronwyn, the Doctor finds an 'interstellar space-hopper' and, in the lamp room of the lighthouse, a psychic transmitter/receiver. Understanding that this is causing the children's nightmares, in turn realising the monsters they dream about, the Doctor is reluctant to dismantle the machine and risk damaging the children. He cannot reach the controls of the telepathic circuits as they are underneath the machine.
Meanwhile, Rose has entered the rectory in search of further information. She is discovered by the 'medical technicians' who reveal themselves to be the lizard-like Cynrog who, under their chief priest Peyne, are manipulating Morton. Rose is subjected to a mind-scan. The Doctor is alerted to Rose's capture when a Slitheen and a Nestene Consciousness are created and a Dalek is heard nearby.
Having instructed the villagers to keep the children awake (to prevent the appearance of more monsters), the Doctor rushes to rescue her; however, she has already escaped with the help of one of the village girls, Ali. She tells the Doctor of a strange monster she has seen in the rectory library.
The Doctor sends Rose (with the sonic screwdriver) and Ali to Bronwyn, so she might take them to the lighthouse, in the expectation that the smaller Ali can reach under the alien machinery to alter the settings so it no longer affects the children.
The Doctor takes Rose's place in the rectory. Following Rose's brain-scan, Peyne and Morton know he is a Time Lord, and are excited by what they might gain from him. They show him the monster in the library. The Doctor deduces that the body is empty, created from the nightmares of the children. Peyne admits that the body is to receive the soul of Balor, their warrior general who had crashed on Earth eighty years earlier. His original body dying, he transferred his soul into the child witnesses of the crash: Morton and the other 'people' attached to the machines.
Moving into the final phase, Peyne orders her Cynrog technicians to attach both the Doctor and Morton to waiting machines, and alters them to induce sleep in the wakeful children so she might continue to harness their imaginations.
The Doctor uses the telepathic machines (which operate at the same frequency as the TARDIS's) to take control. He investigates the memory of the other victims and, through the vision of the small boy - who has appeared at intervals throughout the story - discovers that Bronwyn also witnessed the crash, and contains some of Balor's soul. 'Hitching a ride' on the telepathic waves, the Doctor contacts Rose, instructing her how to alter the machinery to affect adults rather than children.
The newly created Balor, missing a part of his soul, is mad and ungovernable, wreaking havoc throughout the house. Peyne frees the Doctor, blaming him. 'Balor' takes Morton's mind and revenges himself on Peyne. Before 'Morton-Balor' can attack the Doctor, Ali and Rose succeed in changing the settings on the alien transmitter. The village children wake and the adults dream, starving Balor of imagination and shrinking him until the neuroses of the adults become so trivial he ceases to exist.
Before the alien machines in the rectory are destroyed by the resulting fire, the 'polarity is reversed' and, connecting to Bronwyn, it transfers all the life-force into her. She becomes young again.
The Doctor orders the remaining Cynrog to leave in their spaceship, sending them '40 or 50 parsecs' out of their way, and hinting to Rose that their stasis will be tormented by nightmares of him.
