Within events of the first game, Alice Liddell, believing herself responsible for a fire that consumed her home and her family, escapes into a twisted version of Wonderland. While held at Rutledge Asylum for treatment, Alice was able to conquer her doubts, and eventually was released from the ward. Madness Returns takes place in 1875, a year after Alice's release. Alice, now 19 years old,[6] resides at an orphanage in Victorian London, under the care of Dr. Angus Bumby, a psychiatrist who uses hypnosis to help his child patients forget their memories. Though she believes that she is fine, Alice still suffers from hallucinations of Wonderland.

During an errand, Alice is struck by a hallucination and believes herself to be in Wonderland again. Though initially idyllic, the peaceful land quickly becomes corrupted by the Infernal Train that rampages through it, leaving behind the Ruin, a force that attempts to stop Alice. Alice meets with the Cheshire Cat who affirms that it is some outside force, not Alice, that has caused this corruption, and urges her to seek out former friends and foes to discover the source of the Train. Throughout the rest of the game, Alice briefly returns to reality between episodes occurring within Wonderland. In the real world, Alice learns from the family lawyer that her sister, Elizabeth (nicknamed "Lizzie"), was first to die in the fire, despite being the farthest from its source, and had been locked in her room.

Within the corrupted Wonderland, Alice attempts to learn more from Wonderland's various citizens, including the Duchess, the Mad Hatter, the Mock Turtle, the Walrus and the Carpenter, and the Caterpillar. She is ultimately told that the Queen of Hearts still lives despite her defeat at Alice's hands before, though in a diminished capacity. At the Queen's castle, Alice discovers the Queen's true form, which resembles her younger self. The Queen reveals that an entity called the Dollmaker has taken over the Infernal Train and is corrupting Wonderland.

Returning to London, Alice starts to recall her memories of the night of the fire and realizes that Dr. Bumby was there. He is responsible for the death of her sister and her whole family. She comes to the conclusion that Dr. Bumby is attempting to erase the memories of the fire from her mind and, as he has done with other children, trying to leave her as a "blank toy" to be taken by abusive masters and child molesters for a price. Furious, Alice confronts both Dr. Bumby in the real world at the Moorgate station and Dr. Bumby's Wonderland counterpart, the Dollmaker, in her fantasy on the Infernal Train. Dr. Bumby admits to his crimes, and even attests to setting Alice's home on fire after Lizzie refused his advances, removing any witnesses to his having raped her that night. He points out that by wiping out her Wonderland, he will make her forget the events of that night, while he will continue as a member of high society. Alice defeats the Dollmaker in Wonderland, giving her the strength in the real world and in her mind to push Dr. Bumby into the path of an oncoming train, killing him.

As Alice leaves the station, she finds herself in a hybrid vision of London mixed with Wonderland, Londerland. Alice wanders into the unknown terrain as the Cheshire Cat monologues that Alice has found the truth that was "worth the pain fighting for", and Wonderland, though damaged, is safe for the time being.