Wallace and his dog, Gromit, operate a window cleaning business. Wallace falls for the wool shopkeeper Wendolene Ramsbottom. Her sinister dog, Preston, rustles sheep to supply the shop. After a lost sheep wanders into the house, Wallace places him in his Knit-o-Matic, which shears sheep and knits the wool into jumpers. Wallace names the sheep Shaun.
Preston steals the Knit-o-Matic blueprints. When Gromit investigates, Preston captures him and frames him for the sheep rustling. Gromit is arrested and imprisoned, while Wallace's house is inundated with sheep. Wallace and the sheep break Gromit out of jail and hide out in the fields. Wendolene and Preston arrive in the lorry to round up the sheep. When Wendolene demands Preston stop the rustling, he locks her in the lorry with the sheep and drives away, intent on turning them into dog food.
Wallace and Gromit give chase on their motorcycle. When Gromit's sidecar detaches, he activates its aeroplane mode and resumes the chase from the air. Wallace becomes trapped in the lorry and he, Wendolene, and the sheep are transported to Preston's factory, where Preston has built an enormous Knit-o-Matic. The captives are loaded into the wash basin, but Shaun escapes. Shaun activates neon signs to reveal the factory's location to Gromit, who attacks Preston. Shaun sucks Preston into the Knit-o-Matic, removing his fur. Wendolene reveals that Preston is a robot created by her inventor father.
When the Knit-o-Matic dresses Preston in a sweater made of his fur, he inadvertently hits the controls, and the group become poised to fall into the mincing machine. Shaun pushes Preston into the machine, crushing him. Gromit is exonerated and Wallace rebuilds Preston as a harmless remote-controlled dog. Afterwards, Wallace is saddened when Wendolene leaves and tells him that she is allergic to cheese. When he tries to cheer himself up with some cheese, he finds that Shaun has eaten it all.
