Following the introduction sequence set in Arkham Asylum psychiatric hospital, the game begins on September 6, 1915, as police detective Jack Walters (voiced by Milton Lawrence) is summoned to a decrepit manor house in Boston, Massachusetts. The manor is inhabited by a small bizarre cult called the Fellowship of the Yith, led by one Victor Holt who has asked specifically for Walters to come and talk to him. Taking cover from an ensuing firefight, Jack finds himself separated from the police and trapped inside the mansion, with no option but to investigate. When the rest of the police finally break in, they find the cultists dead by mass suicide and Walters apparently insane. He is committed to Arkham sanatorium, where he stays for several years.
Six years later, Walters is released and becomes a private investigator. On February 6, 1922, he takes up a missing person case at Innsmouth, a xenophobic coastal town, and the site of the recent disappearance of Brian Burnham, a clerk that had been sent there to establish a local store for the First National Grocery chain. Arriving in the isolated town, which appears to be depopulated and in a state of collapse, Jack unsuccessfully asks around for Brian. He stays the night at a hotel, where he barely escapes an assassination attempt and then flees from a chase by an armed mob.
From that point forward, Jack is forced to sneak through the alleys, buildings and sewers of Innsmouth, avoiding murderous patrols of the town's corrupt police and the cultists looking for him. He acquires weapons to defend himself and meets undercover agent Lucas Mackey, who tells him that the town is under government investigation. Jack eventually finds Burnham and his girlfriend Ruth, but their car crashes when they escape from Innsmouth, killing Brian and injuring Jack (it is left unknown if Ruth was killed or not).
Jack recovers from the incident and, following a brutal interrogation, he is taken in by the FBI, personally led by J. Edgar Hoover. On February 8, Jack helps Hoover and the FBI raid the Marsh Gold Refinery, where he is attacked by an ancient creature known as a Shoggoth and uncovers a Cthulhu shrine. The refinery is then demolished through the use of explosives.
After the refinery raid, the U.S. military begins a combined land-and-sea invasion of Innsmouth on February 9. The only thing that proves problematic to the full scale assault is the headquarters of the Esoteric Order of Dagon, a religious organization centered on two undersea demigods and Cthulhu that holds the whole town under its grip. The building proves unbreachable for the Coast Guard and the Marines, but Jack finds a way in through an old smuggling entrance (guarded by a star-spawn of Cthulhu.) Inside, Jack frees Agent Mackey, who has been kidnapped for a ritual sacrifice, and puts down the magical shield protecting the building. After discovering a secret chamber, he falls through the floor of a tunnel which leads into the sea.
Jack is rescued by the USS Urania, a Coast Guard cutter which is part of a group heading to Devil's Reef on February 10, following up on a lead provided by the FBI. On the way there, wizards on the reef summon powerful tidal waves to destroy the flotilla, but Jack commandeers the ship's cannon and kills them. The humanoid fish-men known as Deep Ones launch a massed attack on the Urania, killing most of the crew and disabling the engines. Jack manages to reactivate the engine only to have the gigantic Father Dagon himself attack him on the bow. Jack manages to defeat the demigod with the cannon, but not before it causes the Urania to sink. Jack survives the encounter and finds himself on Devil's Reef, where he discovers old smuggling tunnels beneath the seabed, leading him to the underwater city of Y'ha-nthlei.
The city is found to be located below Devil's Reef and is the home of the Deep Ones and members of the Order. Navy submarines attempt to torpedo Y'ha-nthlei, but are stopped by a magical barrier protecting the city. The Temple of Dagon is the source of the barrier, but the entrance is sealed off to prevent any interference. Jack finds another way in through ancient tunnels feared by the Deep Ones at the bottom of the city's foundations. Apparently, this passage, which leads to the temple, is an ancient prison for flying polyps, the enemy of the Great Race of Yith. Jack manages to defeat them with the help of a Yithian energy weapon. Jack then enters the Temple of Dagon and kills Mother Hydra, whose song is generating the barrier, by deafening some of the Deep Ones to her song, allowing him to take control of them. With the barrier down, the submarines attack the city, while Jack escapes through a portal leading back to the Order's headquarters.
In the end, it is revealed that a Yithian swapped minds with Jack Walter's father during the moment of Jack's conception. In flesh, Jack Walters is human, but he inherited Yithian psychic powers, which was the reason for the cultists' interest in him, and explains why he has visions of coming danger and of the Yithian library-city of Pnakotus, as well as his ability to control Deep Ones in the Temple of Dagon. Confined back into Arkham Asylum, Jack hangs himself on February 16, 1922, unable to handle the reality of himself and what he has witnessed. The game is supposed to be "based on the writings in Jack's journal, which were discovered in 1924."