Also featured in the film are Helen Reddy, Mickey Rooney, Jim Dale, Red Buttons, Jeff Conaway and Shelley Winters. The film was directed by Don Chaffey, and the songs are by Al Kasha and Joel Hirschhorn.
The song "Candle on the Water" received an Academy Award nomination, but lost to "You Light Up My Life" from the film of the same title. Helen Reddy's recording (with a different arrangement than the one her character sings in the film) was released as a single by Capitol Records, reaching #27 on the Adult Contemporary charts. The movie also received a nomination for Original Song Score and Its Adaptation or Adaptation Score, losing to A Little Night Music. The film was also a failure at the box office
The next morning, Pete thanks Elliott for helping him. It is revealed that Elliott can be visible or invisible at will; however, the original script had called for him to remain invisible throughout the entire film. They travel further and eventually arrive at Passamaquoddy, a small fishing town. Before entering it, Pete tells Elliott that he must be invisible so as not to frighten the people. Elliott reluctantly agrees. Even so, Elliott makes his presence known by knocking over things, making footprints in wet cement, breaking fences and eggs, frightening a horse, and deliberately affronting a sharp-tongued schoolteacher. Pete is immediately labeled unlucky and is forced to hide while the townspeople pursue him.
A man named Lampie (Mickey Rooney) drunkenly comes out of a tavern and sees Pete and Elliott (who has become visible again). When Lampie realizes he is seeing a dragon, he runs back into the bar to warn the townsfolk. No one believes that Lampie saw a dragon, and therefore they mock him. He is rescued by his independent, grown-up, capable daughter Nora (Helen Reddy). When Lampie and Nora return to their home, the Passamaquoddy lighthouse, Lampie tells Nora of his encounter. Nora ignores this and sends him to sleep. She then steps outside and perceives Pete walking along the water's edge.
Pete and Elliott sit in a sea cave near the lighthouse, where Pete rebukes Elliott for causing trouble and worries about his own future. He is discovered by Nora, who out of compassion invites him into the lighthouse and feeds him. There, he explains his history and his desire to escape from the Gogans. Nora promises that Pete will be safe in the lighthouse, and offers him a bed. En route to the bedroom, Pete sees a picture of a man and asks whom it depicts. Nora answers that it is her fiancé Paul, a sailor whose ship has been missing for a long time. Pete tells her that he will ask Elliott about Paul, because “he [Elliott] has a way of knowing things”. When asked, he explains that Elliott is his dragon. Nora believes Elliott to be an imaginary friend, and that Pete is trying to cheer her up; therefore she pretends to believe that Elliott will help her.
The next morning, two swindlers by the names of Doc Terminus (Jim Dale) and Hoagie (Red Buttons) come into Passamaquoddy on what is apparently a wind-powered cart, having escaped from what is either a lynch mob or a police force. The town's population is immediately upset by his appearance, having previously had experience of Terminus, who is a quack doctor and a medical school drop-out. Terminus tries to sway them back into buying his phony medicines for a dollar apiece (while repeatedly mispronouncing the name of the town, saying things such as "Passamashloddy"; in fact, he never says it correctly throughout the film).
Nora buys Pete a new suit, which he later shows Elliott, additionally taking the picture of Paul as a means of recognizing its model. Meanwhile Lampie has insisted that Elliott stay away from the lighthouse. After Pete goes down to the cave, Nora thanks her father for pretending that the dragon exists, since she believes that this "fantasy" maintains Pete's emotional security. When Lampie reveals that he is still convinced he saw a dragon, Nora tells him to be realistic. He replies that she is hypocritical to talk about being realistic, having been waiting a year for a man who will never come back. Seeing that this hurts her, Lampie apologizes and goes to the hardware store, whereupon Nora climbs to the top of the lighthouse to sing "Candle on the Water", a haunting and romantic song metaphorically linking her love to the light.
Whether or not Lampie visits the hardware store is never revealed; he is next seen in a tavern, where he drunkenly reveals Elliott's existence to Terminus and Hoagie. Although Terminus disbelieves his story and makes excuses not to pursue it, Hoagie follows Lampie to Elliott's cave. Both of them have inebriated themselves before going. In the cave, they frighten themselves and Elliott with exaggerated descriptions of a terrifying monster that Elliott does not initially realize is a hyperbole of himself. When all three face each other, Elliott is slightly annoyed by having been frightened purposelessly. Hoagie later offers Elliott some liquor as a gesture of peace; the drink, however, reacts violently with Elliott's metabolism, triggering an explosion of fire from his mouth that chases both men out of the cave. Hoagie later tells Terminus of this, but is not believed.
However tolerant Nora is of Pete, the town is not; the next morning when Pete goes to school (somewhat reluctantly; he is persuaded only by Nora's suggestion that to be uneducated is to resemble the Gogans), he is shunned by nearly everyone except the curious children. Noticing that the fishermen are overly superstitious and consider Pete a jinx, Nora tells them to calm down and that there is no connection between Pete and Elliott and the unreliability of fishing grounds. This provokes another song, relating to the presence of "room for everyone in this world".
The schooteacher, Miss Taylor, thinks Pete has a distracting imagination and punishes him for it. To save Pete from corporal punishment, the invisible Elliott breaks through a wall of the school, to the amazement of the onlookers. Seeing this, and eager to make a profit, Terminus is hopeful that Pete will sell him Elliott. He plans to kill the dragon and cut him up for use in patent medicines.
Doc Terminus and Hoagie go to the lighthouse the next morning to find Pete and Nora, who are giving the lighthouse a fresh coat of paint. Terminus makes Pete an offer of money, but Pete responds that Elliott is not his to sell, and plays a joke on them by pointing out to them a place that may or may not contain Elliott, who if there is invisible. The two crooks are subsequently chased away by Nora's foghorn. Nora and Lampie then request Pete to remain with them for the rest of his life. Elliott, too, is allowed to stay, provided that he lives in the cave. Pete, Lampie, and Nora cheerfully continue painting and begin cleaning the lighthouse, singing a lighthearted song called "Brazzle-Dazzle Day".
The Gogans are still looking for Pete; therefore they come into Passamaquoddy. When they mention the dragon to some townsfolk, several people are scared; from this, the Gogans know they have come to the right place. Hoagie overhears the inquiries about Pete, and informs Terminus of these new developments. While Pete, Nora, and Lampie are catching lobster, the Gogans find them. They try to convince Nora that Pete is theirs by virtue of a bill of sale. Nora, a passionate, outspoken woman, refuses to hand Pete over. When the Gogans commandeer a boat, Elliott, invisible, knocks them spectacularly into the water.
Terminus later visits the Gogans, convincing them that he will give them Pete if they help him capture Elliott. He gathers allies among the superstitious who take the dragon as a sign of misfortune, and prepares a trap.
Elliott, meanwhile, has located Paul and informs Pete of this. Nora, however, has received news to the contrary and refuses to co-operate with Pete's belief in Elliott any longer. Even Lampie begins to doubt he saw a dragon. Pete, however, is largely undeterred.
Terminus lures Pete to the town's boathouse, while the frightened Hoagie does the same to Elliott, telling the dragon that Pete has been captured by the Gogans. This arouses Elliott's wrath; furious, he carries Hoagie to the boathouse, guided by the terrified man's directions. When the dragon arrives, invisible, he finds that Hoagie's story is true; the Gogans have seized Pete and are holding him painfully. Elliott advances, but is caught in a net. In the fight that follows, Elliott throws away both his invisibility and his bonds, scattering the volunteer roustabouts, and searches for Pete. In a last effort, Lena Gogan shows Elliott the bill of sale that declares her Pete's legal guardian. Elliott sets the paper on fire, tips Lena Gogan into a barrel of creosote, and chases off her horse.
Terminus, desperate, brings his harpoon gun, with which he had planned to kill Elliott, to bear. He is just about to fire when he realizes that a rope connected to the spear is looped around his ankle. He diverts the cannon, but is unable to stop it from shooting him through the ceiling. The harpoon lands embedded in a pole, leaving Terminus dangling. Elliott destroys Terminus's vardo, with which the cheat had traveled.
Just as Elliott turns to go, an electric wire-pole falls, threatening to shock the mayor and the schoolteacher. Elliott, now visible, stops it from doing so, provoking the famous line "There really is a dragon!".
Off the coast, a ship is headed for the jagged rocks of a reef. The Passamaquoddy lighthouse has been hit by a monstrous wave that shattered the Lantern Room windows, drenching the oil-burning lamp, and Lampie cannot find a dry wick. Elliott arrives just in time to light the lamp with his own fire. As he is trying to do so, Nora comes in and is astonished by his presence. After several failures, the light blazes, and the ship is saved.
The saving of the ship enables Elliott to become accepted by the townspeople as a heroic figure or guardian. The economy prospers, and the mayor is humbled. Nora's love Paul returns, the sole survivor of the wreck of which Nora was informed earlier. Paul had lost his memory until an intervention by Elliott restored it. He later sailed aboard the ship that was saved by Elliott's relighting the lighthouse's lamp.
Elliott, however, has sad news. Because Pete is now safe and has a loving family of his own, the dragon must move on to help other children. Pete and Elliott say their goodbyes, and Elliott flies off to his next assignment.