A small group of children on Hōrai Island (whom we later learn to be half-demon) watch as a Kikyō look-alike develops in a green orb, then stand in front of the Cauldron of Resonance while it comes to life. Four scars, the Mark of the Four War Gods (Ryūra, Jūra, Kyōra, and Gōra), appear on all of the children's backs except for the youngest girl, Ai. Asagi, the oldest, tells Ai to leave the island while she still does not bear the mark and says her goodbye. The Four War Gods find out that Ai has escaped and try to retrieve her, but Inuyasha and the others defeat Gōra and save Ai, who later asks Inuyasha to save the others on Hōrai Island. Later, while Ai rests, Inuyasha explains the myth of Hōrai Island, a place that appears once every fifty years. He remembers fifty years ago, when Kikyō took him to the island to meet the half-demon children. Suddenly, the Four War Gods appeared. Gōra sucked some of Kikyō's blood (which was used to make Kikyō's doppelganger), and Ryūra marks Inuyasha's back with the scar, saying that he would never be free from them once he has the scar on him. The gang decides to head to Hōrai Island to investigate.
The villagers all panic upon seeing the island. In a small hut, Kikyō listens to a man's tale of Hōrai Island, then leaves, saying she will defeat the demons. The rest of the villagers rush to the shrine and start praying for divine protection from Kyōra, who proceeds to burn down the shrine and kill many of the villagers. Sesshōmaru arrives and drives Kyōra off with his Dragon Strike. After the battle, he remembers back to his first encounter with Kyōra, when he was marked by the scar.
As Inuyasha and company near the island, Jūra appears and fires his Thunder Cannon at them, destroying their boat. Miroku and Sango fly away on Kirara, pursued by Jūra, while Inuyasha, Kagome, and Ai escape to the beach, where they meet Ryūra. In the ensuing fight, Ryura easily deflects Inuyasha's Wind Scar with his Earth Dragon Gale, then calls upon his Dragon Lightning and nearly kills Inuyasha, but Kagome stops him by firing a sacred arrow. Ryūra is forced to retreat, but not before he hurls some insults at Inuyasha.
Ai leads the group to the village, where they find Asagi singing the "Song of Parting," together with the other four children. When Inuyasha reveals his plan to confront the Four War Gods, Asagi begs him to reconsider, saying they'll all be killed. The gang learns that Asagi is going to sacrifice herself to the Cauldron of Resonance, and she argues that her death will allow the others to live a little longer. They all follow Asagi to the Cauldron, where Inuyasha attempts to destroy the Cauldron with no success. Suddenly, he and Asagi are pulled into the Cauldron as it closes. On the outside, the rest of the gang and the children try to open the doors, while on the inside, Inuyasha feels his strength waning. Then, Lady Kanade, the priestess who fought the Four War Gods fifty years ago, appears. After telling Inuyasha after more about the history of the island, Lady Kanade lends Inuyasha her remaining strength along with the War Gods' power spheres, telling him to destroy it as soon as possible and that it must never be opened. In return, she asks Inuyasha to save the children, then gives her blessing to Asagi before she disappears. Inuyasha calls upon Adamant Barrage and destroys the door to the Cauldron, accidentally breaking Kagome's bow in the process.
Just then, a Kikyō look-alike appears and takes the power spheres from Inuyasha. He chases her to the War Gods, where she opens the box, releasing the spheres to their owners. While Kagome, Shippō and the children attempt to make a raft to escape, the Kikyō doppelganger attacks Inuyasha. At the Cauldron of Resonance, Sesshōmaru appears and finds Kyōra waiting for him. Sesshōmaru easily defeats him with another Dragon Strike. Meanwhile, Sango and Miroku fly on Kirara to confront Jūra and the resurrected Gōra. Using his Wind Tunnel, Miroku redirects Gōra's blasts so that it hits Jūra, before Sango finishes him off with Hiraikotsu.
Meanwhile, Inuyasha battles with the Kikyō doppelganger and is about to lose when the true Kikyō appears and defeats the impostor, then leaves her bow behind. Inuyasha finds Ryūra attacking Kagome and the children, and kills him with his Backlash Wave. With only Gōra remaining, Miroku spears Gōra's head with his staff, greatly weakening it. With a combination of Sango's Hiraikotsu and Inuyasha's Wind Scar, they kill the last War God.
However, the battle does not end here; all the power spheres combine to create one final War God who seems unstoppable. Kagome knows only a combination of her sacred arrow and Inuyasha's Bakuryūha can destroy it, but she cannot fight because her bow was broken. However, the fireflies (spirits of the island residents who had been previously sacrificed, which is Shion's mother) lead the Shion to Kikyō's bow. On the way back, the children join hands and bring the bow to Kagome. Finally, with the fireflies' blessing and Kagome's arrow, Inuyasha unleashes his Backlash Wave to defeat the War Gods. As the gang and the children leave the island, it crumbles into the ocean, putting the myth of Hōrai Island to rest.
As the credits roll, it is indicated that the children spend some time with the gang at Kaede's village before departing as a group of six to face the world by themselves.
- This is the only film in which Myōga does not appear except in the credits.
- This is the only film in which no scenes take place in the modern era.
- This is the only film which doesn't end with Kagome saying 'sit' to punish Inuyasha.
- The warm-hearted, brotherly relationship between the Shitōshin is reminiscent of the Shichinintai.
- Ryūra has many similarities with Bankotsu, leader of the Shichinintai.
- Kyōra is similar to the character Suzaku from the series. Both are red-clad effeminate men associated with birds and fire.
- During the final battle, Shippō says he can turn into a bow, but not an arrow. This is a reference to at least two separate occasions: during the Thunder Brothers arc, and during the second film, both in which, at a clinch moment, Shippō transformed into a bow so Kagome could help Inuyasha fight.
- In this movie, Inuyasha uses the Backlash Wave twice without actually countering a demonic blast of yōki. How this is possible is unknown since the Backlash Wave is used to overpower and return an enemy's yōki with greater power.
- Similar to the rest of the InuYasha franchise, several of the plot elements in this case, Hōrai Island, namely are taken from real Japanese myth and lore and given a spin to coincide with the series. (See the Wikipedia article here.)
- The credits suggest that Jaken was the one who ruined Kagome's bicycle, though Inuyasha was blamed.