Arthur lives underground with Grandfather (they're not blood related, but Grandfather has cared for Arthur all his life). During one of Arthur's excursions to the upper world to gather food, he sees something strange: a cheese hunt. Arthur uses wings and a walkie-talkie in the form of a doll (both invented by Grandfather) to investigate, but disaster strikes, and the hunt's leader, a nasty guy called Snatcher, takes Arthur's wings away and tries to capture him.
Luckily Arthur hides… in a place with monsters. Turns out Arthur has stumbled into the messy home of Willbury, a retired lawyer, who shares his space with friendly monsters such as boxtrolls and cabbageheads. They promise to help Arthur find his way back home, but then some weird things happen: Every hole underground that the boxtrolls know of has been sealed shut, and then a sketchy-looking dude shows up at Willbury's door, offering to sell him some miniature monsters: boxtrolls, cabbageheads, trotting badgers, and a freshwater sea-cow.
Willbury buys the mini-monsters and turns them over to the care of the other underlings, and next on the docket is a trip into town for more information and some groceries. There's a strange-looking lady there (Madame Froufrou), selling mini critters and claiming that they're the height of fashion.
Next Willbury and Arthur meet up with Marjorie, an inventor who suspects that her invention has been stolen. She agrees to tag along and help Arthur find his wings, but when they get back to Willbury's place, there's a major problem: The underlings have disappeared, and it looks like there was a struggle. Right then a dude with a talking rat on his head shows up to see if they're interested in their laundry services. After talking, everyone realizes that they've been affected by kidnappings, so they decide to join forces.
Arthur, Willbury, and Marjorie accompany Tom and Kipper (the rat and the human) to their ship, where they meet with the captain to discuss the disappearances. The sketchy men hunting cheeses at the Cheese Hall are involved… but how? They decide to keep watch on the Cheese Hall in shifts, but then Arthur has the bright idea of sneaking in when the sketchy dudes are on their way out.
Alone in the Cheese Hall, Arthur finds his underling friends in a prison, not but the key to free them. He also finds where his wings are locked up inside a lab. He hides when the men return from the cheese hunt, and witnesses what looks to be a bizarre feeding ritual. The cheeses are melted down and fed to… something large? When everyone goes to sleep, Arthur nicks the keys from Snatcher, and Grandfather talks to him through the doll so he can fix the wings up. There's a mad dash to free the underlings and get out before the bad guys notice, but they make it. Phew.
Once back at the ship, however, Arthur is forced to return to Snatcher's custody when Snatcher bribes the police to take his side. He's locked in the dungeon under the Cheese Hall. Arthur discovers that the dude in the cell next to him, Herbert, was actually Grandfather's childhood friend.
Through the doll, they talk to Grandfather and Arthur learns for the first time why they have to live underground: Grandfather and Herbert were falsely accused of attempted murder by Snatcher a long time ago. Now that Arthur has found Herbert, though, they stand a chance of clearing everyone's name.
The police are still keeping everyone from leaving the ship under threat of arrest, but the humans and rats all disguise themselves as boxtrolls by putting on boxes and are able to sneak past the police to get underground; they try to enter the Cheese Hall that way. The underground is on the verge of being uninhabitable due to flooding, though, since the boxtrolls that normally maintain the waterworks have all disappeared. Willbury finds Grandfather to help bring him to safety, but then they are captured by Snatcher's minions, who need more underlings for their evil scheme.
Grandfather's doll is able to move by itself and get the keys from the guard who's dozing outside Arthur's cell, so Arthur frees himself and Herbert. Snatcher has just shrunk Marjorie, stealing her size by using her own re-sizer invention. The size goes to Framley, a rat that went missing from the ship and is now as large as the elephant.
Snatcher plans to use Framley to wreak havoc on the town of Ratbridge so that he and the rest of his minions can rule Ratbridge. Herbert uses his mallet to free everyone and smash a hole in the wall so that they can escape back to the ship, but when everyone realizes the extent of Snatcher's plan, they head back to the Cheese Hall.
Snatcher rides his war-rat out to start destroying the town. Arthur and the rest come back to the Cheese Hall too late to stop him, but then Marjorie rigs up a giant magnet that catches hold of the minions' weapons and the armor that the rat is wearing, dragging them all back toward the Cheese Hall so they can't destroy too much of the town. The rat explodes into a mess of cheese that covers the town, while Snatcher gets away. Everyone else is safe for now, though.
Arthur and Grandfather are reunited at last, and Willbury and the crew of the ship help rent rooms for Arthur and Grandfather right next to Willbury's home. The Cheese Hall has sunk underground, and the giant pit, filled with water, makes a perfect swimming pool. In the case against Snatcher, who has disappeared, the court awards Grandfather the right to charge access to the pool.
Marjorie and the other underlings remain mini-sized until they figure out that they can take the size out of all the fashionable ladies whom a cross-dressed Snatcher fooled into thinking large bottoms were fashionable. So Marjorie uses her machine to suck the size out of ladies' butts and restore her own size and that of the miniature underlings. Yes, you read that right: their butts.
So Arthur gets to finally live aboveground with Grandfather, and now he has friends like the boxtrolls and other underlings, Willbury, the crew of the ship, and Marjorie. Ratbridge ain't such a bad place after all.