In 18th century Qing dynasty China, Li Mu Bai is an accomplished Wudang swordsman and Yu Shu Lien heads a private security company. Yu Shu Lien and Li Mu Bai have feelings for each other, but because Shu Lien had been engaged to Mu Bai’s close friend, Meng Sizhao, before his death, Shu Lien and Mu Bai feel bound by loyalty to Meng Sizhao and have not acted on their feelings for one another. Mu Bai, choosing to retire, asks Shu Lien to give his sword “Green Destiny” to their benefactor Sir Te in Beijing. Long ago, Mu Bai’s teacher was killed by Jade Fox, a woman who sought to learn Wudang skills. While at Sir Te’s place, Shu Lien makes the acquaintance of Jen Yu, who is the daughter of rich and powerful Governor Yu and is about to get married.
One evening, a masked thief sneaks into Sir Te’s estate and steals the Green Destiny. Sir Te’s servant Master Bo and Shu Lien trace the theft to Governor Yu’s compound, where Jade Fox had been posing as Jen’s governess for many years. Soon after, Mu Bai arrives in Beijing and discusses the theft with Shu Lien. Master Bo makes the acquaintance of Inspector Tsai, a police investigator from the provinces, and his daughter May, who have come to Beijing in pursuit of Fox. Fox challenges the pair and Master Bo to a showdown that night. Following a protracted battle, the group is on the verge of defeat when Mu Bai arrives and outmaneuvers Fox. Before Mu Bai can kill Fox, the masked thief reappears and helps Fox. Fox kills Tsai before fleeing with the thief (who is revealed to be Jen). After seeing Jen fight Mu Bai, Fox realizes Jen had been secretly studying the Wudang manual and had surpassed her in combat skills.
At night, a desert bandit named Lo breaks into Jen’s bedroom and asks her to leave with him. A flashback reveals that in the past, when Governor Yu and his family were traveling in the western deserts, Lo and his bandits had raided Jen’s caravan and Lo had stolen her comb. She pursued him to his desert cave to get her comb back. However, the pair soon fell passionately in love. Lo eventually convinced Jen to return to her family, though not before telling her a legend of a man who jumped off a cliff to make his wishes come true. Because the man’s heart was pure, he did not die. Lo came to Beijing to persuade Jen not to go through with her arranged marriage. However, Jen refuses to leave with him. Later, Lo interrupts Jen’s wedding procession, begging her to leave with him. Nearby, Shu Lien and Mu Bai convince Lo to wait for Jen at Mount Wudang, where he will be safe from Jen’s family, who are furious with him. Jen runs away from her husband on their wedding night before the marriage could be consummated. Disguised in male clothing, she is accosted at an inn by a large group of warriors; armed with the Green Destiny and her own superior combat skills, she emerges victorious.
Jen visits Shu Lien, who tells her that Lo is waiting for her at Mount Wudang. After an angry exchange, the two women engage in a duel. Shu Lien is the superior fighter, but Jen wields the Green Destiny: the sword destroys each weapon that Shu Lien wields, until Shu Lien finally manages to defeat Jen with a broken sword. When Shu Lien shows mercy, Jen wounds Shu Lien in the arm. Mu Bai arrives and pursues Jen into a bamboo forest. Mu Bai confronts Jen and offers to take her as his student. She arrogantly promises to accept him as her teacher if he can take Green Destiny from her in three moves. Mu Bai is able to take the sword in only one move, but Jen goes back on her word to accept him as teacher. Mu Bai throws the sword over a waterfall, Jen dives after it, and is then rescued by Fox. Fox puts Jen into a drugged sleep and places her in a cavern; Mu Bai and Shu Lien discover her there. Fox suddenly reappears and attacks the others with poisoned darts. Mu Bai blocks the needles with his sword and avenges his master’s death by mortally wounding Fox, only to realize that one of the darts hit him in the neck. Fox dies, confessing that her goal had been to kill Jen because Jen had hidden the secrets of Wudang’s best fighting techniques from her.
As Jen leaves to prepare an antidote for the poisoned dart, Mu Bai prepares to die. With his last breaths, he finally confesses his love for Shu Lien. He dies in her arms as Jen returns, too late to save him. The Green Destiny is returned to Sir Te. Jen later goes to Mount Wudang and spends one last night with Lo. The next morning, Lo finds Jen standing on a bridge overlooking the edge of the mountain. In an echo of the legend that they spoke about in the desert, she asks him to make a wish. He wishes for them to be together again, back in the desert, and Jen jumps off the bridge.