Plot

Wallace and his dog Gromit are now operating a window cleaning business. One night, a lost sheep escapes from a lorry that has a sinister looking dog sitting in the front. The sheep enters Wallace and Gromit's house and wanders around inside. The next morning, Wallace and Gromit can see that something strange has happened around the house but can't find the woolly intruder.

They go to a job on their motorcycle and sidecar and upon arriving Wallace meets and falls for Wendolene, a wool shopkeeper who was left the store after her father died. Her dog, Preston, is actually rustling sheep to supply the store. Knowing that the sheep entered their house, Preston goes off to try and get him back. He finds some wool and knows that he's in the house somewhere. When Wallace and Gromit return home, Preston hides in their cellar. Wallace discovers the sheep and puts him into his knit-o-matic machine in the cellar which shears sheep and knits the wool into jumpers. He names the sheep, Shaun. Unbeknown to them, Preston has been watching and steals the blueprints to Wallace's invention.

While cleaning a clock outside Wendolene's, Gromit can see the sinister Preston observing him. Preston uses Shaun to lure Gromit into a trap. Preston captures him in the back of the lorry and frames him for the sheep rustling. Gromit is arrested and thrown in prison. Wallace's house is inundated with the sheep from the lorry that Preston had cleared out in order to capture Gromit. Wendolene appears at the door and tearfully tells him to stay away from her.

Wallace, with help from the sheep, break Gromit out of jail and hide in the countryside. As Wallace tells him he'll have to remain forever on the run, Wendolene and Preston turn up in the lorry to rustle up the sheep. As Wallace and Gromit hide and observe, Wendolene tells Preston that she's sick of his twisted ways and that the rustling must stop. Preston locks her in the back of the lorry with the sheep, including Shaun, and drives off, while Wallace and Gromit pursue them on their motorcycle and sidecar.

During a chaotic chase, the sidecar that Gromit's in becomes detached from the motorcycle and just as he's about to die after falling from a cliff, he activates it's aeroplane mode and pursues Preston in the air while Wallace becomes trapped in the back of the lorry with Wendolene and the sheep.

They are transported to Preston's factory where he has used the blueprints for Wallace's machine to create his own enormous knit-o-matic and plans to turn them into dog food. He loads the captives into the wash basin but Shaun escapes and activates neon signs outside to reveal the factory's location to Gromit who goes flying in, attacking Preston by firing porridge at him from the plane.

Preston is sucked into the machine and his fur is removed which reveals him to be a robot. Wendolene reveals to Wallace that her father was an inventor who created him to protect her but he'd since malfunctioned and become evil. The knit--o-matic makes a sweater out of Preston's fur and dumps it onto his head. Shaun pushes him into the dog mincing machine which crushes him.

Gromit is exonerated and Wallace re-builds Preston into an harmless, remote-controlled dog. But he is saddened when Wendolene tells him she's allergic to cheese. He tries to cheer himself up by having some cheese himself but Shaun has eaten it all instead.