This episode starts when Aang and the gang are all sitting around a camp fire, in the middle of a forest on a mountain, telling ghost stories. Sokka finishes his story, and the group is not so impressed with it. Katara tells the story about her mother's friend who went missing. Then Toph thinks she hears people screaming inside the mountain beneath them. After it stops, an old lady who owns a nearby inn comes out of the woods. They are startled and hug each other. She asks the gang, if they would like to stay in her inn a couple of nights. The gang are very grateful and agree. Sokka, scared, wondering whether he can sleep or not, eventually does so anyways.
A little while later at the inn, the gang hear about people who keep disappearing on the full moon in the nearby village. Sokka inquires more into the subject, but Hama gives him a vague answer, and immediately asks whether anyone would like more tea. She assures the group that they will be safe and shows them to their rooms.
In the morning, Sokka, sleeping with his head on the floor, is awakened by Hama. She tells him that they need to go shopping. Immediately, the scene goes to a marketplace with Hama handing coins to a merchant to pay for groceries. Katara and Hama get into a friendly conversation about taking advantage of men, while the others listen in on a conversation between a townsman and a merchant. The townsman wanted ash bananas, but the merchant was not willing to risk losing another delivery boy because the full moon was on that day. Sokka is confused at the situation, and makes a hypothesis that spirits were behind this. They both agree that Aang should deal with the situation, since he is the Avatar. Hama asks them to go back to the inn, while she takes care of a few errands.
Back at the inn, Sokka gets suspicious and starts to snoop around (much to Katara's chargrin)and finds a load of puppets in a closet. Then Sokka finds a locked door in the attic, which he opens with his sword. Inside, he gets Toph to open this little box, which she just gets open as the old lady gets back and tells them that it is an old comb, and the last thing she has left from the southern water tribe.
They get into a conversation about how she knew that Sokka and Katara were from the Water Tribe. She tells them that they were gathering all the food, so she can prepare a Water Tribe dinner for them. They end up at the dinner table with Hama asking, if they would like more soup. After they agree, she displays her waterbending powers, spreading the soup to all of the bowls. Katara is impressed and asked how she ended up in the Fire Nation. She then tells them the story of how all the water benders were kidnapped from the southern water tribe (hence why Katara is the last water bender of the southern water tribe)
She then shows Katara a lot of water bending tricks, such as how to create water out of thin air, and how to take bendable water from trees and plants.
While Katara is learning water bending Aang and the gang go to look into the mysterious disappearances and find out there is a man in the village who survived the kidnapping. They talk to him and find out that he didn't see anyone, he just couldn't control his limbs. They ask him what happened and he said "I was walking up towards a cave in the mountain but then the sun started to rise and it all stopped". Then Toph realizes that she did hear people screaming in the mountain, and they run off to save them. When they reach the mountain they find a cave with all the kidnapped villagers chained inside. The gang ask what spirit did that to them, and then one man says that it wasn't a spirit it was a witch. Then Sokka figures that it must have been the old waterbending lady, Hama. Toph stays to release the other prisoners, while Aang and Sokka go to save Katara.
While this is going on Katara has gone off with the old lady into the forest, where the lady says she is going to teach Katara a new move, bloodbending. Then Hama tells the story on how she escaped, while she was in the fire nation prison. She was able to bloodbend on every full moon. Water benders develop enough strength to manipulate the blood in a living person. Then Katara figures that she must have been the lady who was kidnapping all the people. The lady then says that they kidnapped her and trapped her in a dirty prison. She tells Katara that she must join her because the Fire Nation sought to destroy their culture. Then, Katara refuses to learn blood bending. A water bending battle ensues where we see all the moves Katara has learned. Then Sokka and Aang arrive to outnumber Hama. Then, she starts bending the blood of Aang and Sokka making them first attack Katara, but when she blocks that and incapacitates the boys, the lady makes them run at each other with Sokkas sword pointed out. But they are saved at the last minute by Katara bloodbending Hama to the ground. The prisoners arrive with Toph and place the lady back in jail with her just saying how she did what she came to do. She gave congratulations to Katara for she now is a bloodbender. The episode ends with Katara falling to the ground crying with the gang around her, the full moon in the background.