The story begins after the defeat of Naraku by InuYasha, Kagome, and their friends. There is some initial doubt as to whether Naraku is truly dead until it is revealed that the cursed void in Miroku's right hand is gone and Kagura's heart is in her body again. The group disbands with InuYasha, Kagome and Shippō off to pursue the remaining shards of the Shikon no Tama.

Miroku returned to his master, and Sango returned to her village to search for Kohaku.

Kagome briefly returns to her time period to catch up in school and happens to be learning about the legend of Princess Kaguya. Kaguya was a maiden from the moon, found by a bamboo cutter in the forest. As suitors proposed to her, Kaguya presented to them impossible tasks before returning to the moon.

Kagura and Kan'na, the two surviving incarnations of Naraku, are somewhat restless now that Naraku is dead. They come across a mirror in a hidden shrine and awaken a maiden who declares herself Kaguya, Princess of the Heavens. In exchange for freeing her, Kaguya promises to give Kagura her true heart's desire, freedom. Kagura and Kan'na set out to recover five items that will free Kaguya from her mirror.

Kohaku has returned to Sango's village without any memory as to who he is. Miroku's master, Mushin, presents him with a task that is to be given to the surviving descendant who defeats Naraku. Miroku is to destroy a yōkai who threatens to cast the world into eternal night, at which the first sign of the yōkai's appearance for the first time in 50 years is a full moon shining for many nights.

Kagome returns to InuYasha's time and the two of them, along with Shippō, go to find the remaining shards of the jewel. InuYasha detects Naraku's presence and runs into Kagura instead. Kagura unleashes her most powerful attack, Dance of the Dragon and InuYasha sends it back to her using his Backlash Wave but is stopped by Kanna who uses her mirror to send the attack back at InuYasha. Kagura manages to rip the sleeve off of InuYasha's kimono. She and Kan'na are about to take their leave when InuYasha is about to finish them off. Kaguya makes her appearance and uses her ability to discern the dark desires of InuYasha's heart against him. Kagome manages to stop Kaguya from inflicting major damage to InuYasha and the demons leave, with Kaguya noting Kagome has a strange aura about her that does not agree with the flow of time.

InuYasha and company leave to pursue Kaguya and run into Akitoki Hōjō, the ancestor of Kagome's classmate, who is supposed to dispose a family heirloom (a hagoromo/celestial robe) into Mt Fuji. He joins them, partly because he has a bit of a crush on Kagome and partly because he is being blackmailed by Shippō for an earlier incident. Meanwhile, Kikyō investigates Naraku's death and has come across a slaughtered village where a dying girl gives her the Stone Bowl of Buddha.

Miroku (with his tanuki servant, Hachiemon) journeys to his grandfather's (given the name Miatsu) grave to find the yōkai he is supposed to destroy. He hears the local legend of the celestial maiden, Kaguya. Miroku's grandfather, who one of the most powerful priests in the series, which is evidenced by the fact that he was able to defeat Kaguya alone, sealed her away into a mirror and was unable to kill her due to her beauty and his own lecherous ways. Kaguya's hagoromo was entrusted to a family that was also given specific instructions for disposing of the robe should Kaguya be freed. Kagura arrives in Sango's village and attacks Kohaku, taking off with the Swallow's Cowrie Shell that was in Kohaku's possession. After Kikyō surrenders the Stone Bowl of Buddha without a fight to Kagura, she and Kanna free Kaguya from her mirror. Kaguya goes to find her hagoromo and runs into InuYasha and Kagome. After pinning InuYasha to a tree,Kagome fires a arrow to kill Kaguya ,but she absorbs it and fires it at InuYasha. Kagome then jumps in front of the arrow and Akitoki throws the hagoromo/celestial robe in between the arrow and Kagome. Then Kaguya takes Kagome.

Kaguya, whose power has increased exponentially now that she has the hagoromo, prepares to freeze time into eternal night. InuYasha meets up with Miroku and Sango again and they prepare to rescue Kagome and stop Kaguya. InuYasha then reclaims his piece of the robe of the fire rat that Kaguya had stolen. It is then revealed that Kaguya was in fact a demon who absorbed the real Kaguya and taken on her beauty and power. As they battle Naraku reappears revealing that he had purposely faked his death in order to absorb Kaguya. However, Naraku during this point in the series was still a half demon and thus wasn't able to battle her on equal terms. Naraku then escapes with Kohaku, Kagura, and Kanna. Kagome then combines her power with that of Miroku as she lauches a piece of his staff in the form of an arrow and destroys Kaguya's mirror. InuYasha then manages to destroy Kaguya's physical form using his backlash wave (Bakuryuha). Kaguya shows up again in the form of a black cloud and attempts to absorb Kagome in an effort to gain a new body. In the end she is destroyed by Miroku's Kazana attack; fulfilling Miroku's grandfather's wish. In the end Akitoki Hōjō throws Kaguya's hagoromo into a volcano to stop any other beings from ever using its power.

Note: This is the only Inu Yasha film where Naraku, Kagura, and Kanna make an appearance, though Naraku's name is mentioned only once in the first movie.