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The movie opens with a fairy tale. Ofelia, a young girl who loves to read, lies on the ground, bleeding, while the narration explains that Princess Moanna of the Underground Realm, curious about the world above, escapes to the Earth, where the sun blinds her and, forgetting her past, she weakens and dies. However, her father retains hope that her spirit will eventually return to him.
The story then cuts to post-Civil War Spain in 1944, with Francisco Franco firmly in power. Ofelia has traveled with her pregnant mother Carmen to join Captain Vidal, her new stepfather and father of Carmen's unborn child, at his post in the mountains where he is rooting out Spanish Maquis guerillas.
Ofelia discovers a stick insect that she believes to be a fairy. It follows her to the mill where Vidal is stationed. Ofelia chases it into an ancient labyrinth nearby. Ofelia meets Vidal's housekeeper, Mercedes, who treats her kindly. Later that night, Ofelia overhears Mercedes and the local doctor conspiring to help the rebels. Upon her mother's request, Ofelia tells a story to her unborn brother, a fable about pain and loss, and the promise of eternal life. After waking her in the middle of the night, the insect appears in Ofelia's bedroom where it changes into a fairy and leads her through the labyrinth. There, she meets the faun, who says he believes her to be Princess Moanna. He gives her three tasks to complete before the full moon to ensure that her "essence is intact" so that she can return to her father's realm.
Ofelia completes the first task of retrieving a key from the belly of a giant toad that lives deep beneath the roots of a fig tree. Ofelia is becoming more worried about her mother, who has been ordered to stay in bed as her condition has worsened. The faun tells Ofelia of a magic way to restore her mother to health. Meanwhile, her stepfather is proving to be a violent, cruel man. Ofelia then undertakes the second task of retrieving an ornate dagger...