The film was nominated for an Academy Award for Best Sound Editing.

The story opens with LAPD Sergeants Martin Riggs and Roger Murtaugh engaged in a car chase with a red BMW E24. After it crashes, they move in to arrest the driver, but find he has escaped. Searching the car, they discover the trunk is full of South African Krugerrands (gold coins which were illegal in the U.S. due to sanctions against the South African apartheid regime). Later that night, Murtaugh and Trish are attacked, tied up to their bed, and gagged at his home by thugs dressed in black hoods, who warn him to cease the investigation around the Krugerrands. When Murtaugh still doesn't relent, they later resort to wiring a bomb to his toilet seat, set to go off when he stands up again; Riggs is able to save his partner from this precarious predicament, though the bathroom inevitably suffers for it.

In the wake of the attack on Murtaugh, he and Riggs are reassigned to a seemingly less dangerous task, protecting Federal witness, Leo Getz (Joe Pesci), a crooked, loudmouthed accountant, who, after feeling his life was in danger, decided to blow the whistle on his money laundering clients. Mere moments after arriving at Getz's hotel room, an assassin posing as room service enters the room and tries to kill Getz. Riggs and Murtaugh subsequently discover Getz has been laundering funds for the same drug smugglers and he leads them to their base of operations, a house on stilts. Riggs recognizes one of the men in the house as the assassin from the hotel. The assassin tries to make an escape by stealing a tow-truck parked outside the house. Riggs jumps onto the back of the tow truck, and Murtaugh and Getz chase after Riggs and the suspect. Later that day, Riggs and Murtaugh return to the house on stilts with full backup of detectives and uniform officers. Attempting to arrest the gang, Riggs and Murtaugh are confronted by Arjen Rudd (Joss Ackland), the minister of affairs for the South African Consulate. Rudd indignantly invokes diplomatic immunity on behalf of himself and his 'staff,' and threatens to report Riggs and Murtaugh to the State Department for violating South African soil.

Although ordered by the Department to leave Rudd and his associates alone, Riggs and Murtaugh are certain that he is the drug trafficker they are looking for and commence a private war against them. While Leo and Murtaugh distract the guards at the consulate, Riggs infiltrates the building and catches the name "Alba Varden," a name that appears familiar to Murtaugh. At the same time, Riggs begins to openly harrass Rudd, and also begins a romance with Rudd's secretary, Rika van den Haas (Patsy Kensit), who strongly dislikes both her boss and her country's policies. Riggs invites her to a dinner at his trailer and they end up sleeping together.

Fed up with Riggs, Rudd has decided to deal with his police problems once and for all. He orders Pieter Vorstedt (Derrick O'Connor), his chief enforcer, to begin a campaign of violence against the LAPD. As a result many of Riggs' and Murtaugh's fellow officers (who all participated in the Krugerrand investigation and the raid on the stilt house) are brutally murdered.

While guarding Getz, Murtaugh views an old family video and finally remembers that Alba Varden is the name of a South African ship currently at the docks. He suddenly realizes that Rudd is planning to use the ship to smuggle his billions in drug money to Cape Town. He is then attacked by two of Vorstedt's men but manages to thwart them with a nail gun. At the same time, Leo is kidnapped while sitting unguarded in Murtaugh's car. While in bed with Rika, Riggs is warned by his barking dog of an impending attack by Rudd's men in two Eurocopter AS350 helicopters. Riggs manages to escape after counter-attacking, using an MP5 of one of the attackers. However, when he returns Rika to her house, he is knocked out and captured by Vorstedt.

As Vorstedt prepares to drop the trussed up Riggs into Los Angeles harbor, he taunts him about the death of his wife. Vorstedt reveals that Riggs, then a narcotics officer in Long Beach, California, had been costing the gang too much money. Therefore, Rudd had ordered Vorstedt to run Riggs' car off the road, but he inadvertently killed Victoria instead. Coldly mocking his bad luck with women, Vorstedt drops the now enraged Riggs off the docks in a straitjacket and leaves him to drown. However, Riggs quickly escapes the straitjacket by dislocating his shoulder (a feat he was used to perform jokingly in front of colleagues, in keeping with his "madman" persona), but finds Rika nearby, drowned. Although Vorstedt has already left, Riggs brutally beats the other two South Africans to death. Seething with hatred, he calls Murtaugh and announces that he is going after Vorstedt and Rudd to avenge the deaths of his wife, Rika, and the rest of their squad. Murtaugh reminds Riggs that they have no authority. Riggs simply replies "I'm not a cop tonight. It's personal." Leaving his own badge at the station, Murtaugh leaves to help him kill Vorstedt and Rudd.

Meeting at Rudd's stilt house, Murtaugh heads inside to rescue Leo. Meanwhile, Riggs uses his truck to dislocate the stilts, causing the house to collapse just as Getz and Murtaugh escape. After sending Getz back to the precinct, Murtaugh and Riggs go to the dock where "Alba Varden" is moored. They enter a cargo container that is sitting on the dock, to discover it is filled with millions of Arjen Rudd's and Pieter Vorstedt's drug money. But their presence is discovered and the cargo container is sealed, and lifted with a crane, with the intent for them to suffocate. However, they use a Mercedes within the container to bust their way out, causing all the money to blow out of the container into the Los Angeles bay. Riggs and Murtaugh rappel down ropes onto the deck of the Alba Varden where they have a final confrontation with Rudd and Vorstedt.

Eventually, Vorstedt and Riggs engage in a brutal hand-to-hand showdown. Riggs eventually stabs Vorstedt with his own knife and leaves him for dead. However, Vorstedt pulls out a gun and aims it at Riggs' back. In the nick of time, Riggs completes his revenge by pressing a button and dropping a cargo container on Vorstedt. Suddenly, Rudd appears behind Riggs and shoots him with a Mauser C96. Outraged, Murtaugh draws his gun and attempts to arrest the diplomat. Rudd holds up his ID and gloats, "Diplomatic immunity." Murtaugh shoots him in the head, replying:"It's just been revoked!"

Running to his partner, Murtaugh finds that, although seriously wounded, Riggs is still alive. Riggs seems to ask for a cigarette and Murtaugh (who often disapproved of his smoking) is quick to retrieve the packet, only to be baffled when Riggs tells him to throw it away as cigarettes "are bad for health": the joke provokes a burst of hilarity in the two buddies; the movie comes to an end amid the chords of "Knocking on Heaven's Door and the sirens announcing the arrival of police cruisers and ambulances.