The group has camped out in the woods for the night. Sokka tells a horror story about a haunted sword, which completely fails to scare the other three. Katara begins to tell a scary story about Nini, a friend of her mother's who disappeared during a harsh winter in the Southern Water Tribe. The story leaves the entire group jumpy, and Toph adds to the fear by saying she can hear screaming coming from under the mountain. An old woman named Hama suddenly appears, offering them a safe place to stay for the night, as people in the woods had been mysteriously disappearing on full moons.
The group accepts her offer to stay with her in her inn. Katara gets along with her very well, but despite the woman's kind treatment, Sokka grows wary of her. The next day, Hama leads her guests on a shopping trip, during which Sokka overhears some of the locals talking about the disappearances during the full moon. When Hama sends her guests ahead of her back to the inn, Sokka investigates the house for anything suspicious, finding a cupboard filled with wooden puppets in a hallway, and a locked door in the attic. Peering through the keyhole, he sees a box lying in the room beyond it, and decides the pick the lock with his sword. After breaking into the room, and Toph Earthbends her meteor bracelet into a key for the box. Just before they manage to open it, Hama walks in and catches them in the act. However, she opens the box for them and pulls out a water tribe comb, revealing she is from the Southern Water Tribe, but was captured a long time ago. She explains that she knows they are from the Southern Water Tribe, too, as she heard them talking in the woods.
During dinner, the group also discovers that she is a Waterbender, as she Bends the soup into their bowls. She tells them her story of how she came to be in the Fire Nation: the Fire Nation captured all of the Southern Waterbenders during raids on the South Pole, over time whittling down their numbers until Hama was the last remaining. She, too, was then captured, and among those taken was the only who managed to escape. Katara is deeply moved by her tragic story, and Hama offers to teach Katara what she knows in order to carry on the tradition of the Southern Waterbenders, and Katara happily agrees to learn, wanting to know more about her tribe's cultural heritage. The next day, she leads Katara to a garden filled with fire lilies, and tells her that water can be drawn from anything. She demonstrates this by gathering the moisture from the air as well as harvesting the water from the flowers around them, before using it for some simple techniques. However, drawing water from the flowers dries and kills them, and while Katara is amazed by the demonstration, she also regrets that the fire lilies were destroyed. Hama dismisses her concerns quickly, reminding her that they were simply flowers. She then tells Katara she has one more technique to teach: one that can only be used at the full moon. When Katara expresses hesitance due to the rumors of disappearances, Hama reassures her, stating that two master Waterbenders under a full moon should be able to handle anything.
Meanwhile, Aang, Sokka, and Toph, believing the disappearances to be the work of an angry spirit, carry out an investigation. However, after briefly exploring the area, Aang concludes that the town is surrounded by natural beauty--the townsfolk have done nothing to disrupt the environment or anger the spirits. Questioning one of the locals leads the group to "Old Man Ding", an elderly man and the only to escape being taken by the spirit. Ding tells the three that he never actually saw a spirit, but rather felt possessed and compelled to walk to the mountain. Unable to control his own movements, Ding almost walked into a cave. But then, the sun rose, and he regained control of his body. Toph realizes that she really had heard screaming coming from under the mountain earlier, and that the captured villagers must be imprisoned there.
As Katara and Hama arrive in the forest, Aang, Sokka, and Toph discover an underground prison. Toph again crafts her bracelet into a key to free the villagers from their chains, and some of those captured state that it was not a spirit at all that captured them, but rather Hama. At the same time, Hama reveals to Katara the story behind her unique skill. While imprisoned by the Fire Nation, she and the other Waterbenders were completely separated from any and all water. The guards pumped in dry air into the cells and made sure the inmates' arms and legs were tied before feeding water to them. However, she eventually realized that water exists within all living things, and began to manipulate water in the bodies of rats that crawled into her cage. This technique, which she calls Bloodbending, could only be used with the influence of the full moon enhancing her abilities. After mastering the technique, Hama controlled one of the guards, forcing him to unlock her cage, and allowing her to escape after decades of imprisonment. Horrified by the idea of controlling another person's body, Katara refuses to learn Bloodbending. Hama argues with her, stating that they must have vengeance on the Fire Nation for wiping out their entire culture. The outburst leads Katara to realize that Hama has been causing the villagers to disappear, but Hama angrily states that the people of the Fire Nation deserve the same treatment that they gave to the Southern Waterbenders. Hearing this causes Katara to adamantly refuse to learn Bloodbending and to stop Hama from further terrorizing the town, and so Hama uses the technique to temporarily force Katara into submission.
However, Katara quickly regains control of her body, reminding Hama that she draws power from the full moon as well, and also stating that her Waterbending is more powerful than Hama's. The two begin to battle, each drawing water from the grass and trees surrounding them, but it quickly becomes obvious that Katara is the superior combatant. But when Katara appears on the cusp of victory, Aang and Sokka arrive to assist her--and succeed in doing little more than providing Hama with an advantage, as she uses Bloodbending to send them against Katara. Katara evades their attacks and manages to freeze both Aang and Sokka to two separate trees to stop them, but this proves to be only a temporary solution. Hama frees them both and resorts to sending them flying at each other, with Sokka's sword pointing straight at Aang. At the last second, Katara uses Bloodbending to subdue Hama and protect Aang and Sokka. Toph arrives with the other villagers, who handcuff Hama and take her away, vowing to imprison her forever. Hama remarks that her work is done, as Katara has already willfully used Bloodbending, and laughs as she is dragged off. Katara breaks down into tears as her friends attempt to comfort her.