In 1954, widower U.S. Marshal Edward "Teddy" Daniels and his new partner Chuck Aule go to Shutter Island on a ferry boat to the home of Ashecliffe Hospital for the criminally insane to investigate the disappearance of a patient, Rachel Solando, who has escaped the hospital and apparently the desolate island despite having been kept in a locked cell under constant supervision.
Visiting Rachel's room, Teddy and Chuck discover a code that Teddy believes points to a 67th patient, when there are allegedly only 66. Teddy also reveals to Chuck that he is there to avenge the death of his wife Dolores, who was murdered two years prior by one of the inmates, Andrew Laeddis. The novel is interspersed with graphic descriptions of World War II and Dachau which Teddy helped to liberate. After a hurricane hits the island, Teddy and Chuck investigate Ward C, where Teddy believes government experiments with psychotropic drugs are being conducted. One inmate tells Teddy that Chuck is not to be trusted.
As Teddy and Chuck return to the main hospital area, they are separated. Teddy discovers an ex-psychiatrist, who says she is the real Rachel Solando, hiding in sea caves. She explains that he has no friends on the island and is himself a prisoner. She warns him to be careful that food, medication, even cigarettes he has taken have been laced with psychotropic drugs. Upon returning to the hospital, Teddy cannot find Chuck and is told he had no partner. He escapes and makes his way to the lighthouse to rescue Chuck where he believes the experiments take place. He reaches the top of the lighthouse and finds only hospital administrator Dr. Cawley seated at a desk. Cawley tells Teddy that he is in fact Andrew Laeddis (an anagram of Edward Daniels) and that he has been a patient at Shutter Island for two years for murdering his wife, Dolores Chanal (an anagram of Rachel Solando), after she murdered their three children, Edward, Daniel, and Rachel.
Andrew/Teddy refuses to believe this and takes extreme measures to disprove it, grabbing what he thinks is his gun and tries to shoot Dr. Cawley; but his firearm is merely a toy water pistol. The man he thinks is Chuck then enters, revealing that he is actually Andrew's psychiatrist, Dr. Lester Sheehan. He is told that Dr. Cawley and Chuck/Sheehan have devised this treatment to allow him to live out his elaborate fantasy, in order to confront the truth, or else undergo a radical lobotomy treatment. Teddy/Andrew finally realizes that he killed his wife and his service as a US Marshal was a long time ago. This breakthrough seems promising for his recovery.
The next morning Andrew/Teddy wakes up, leaves the dorm and sits outside on the hospital steps. Chuck/Dr. Sheehan sits next to him. Andrew/Teddy says to Chuck/Sheehan, "I don't know, Chuck. You think they're onto us?" Chuck/Sheehan replies: "Nah. We're too smart for that." Chuck/Sheehan signals to Dr. Cawley and the guards that he believes the treatment was unsuccessful. Dr. Cawley and the orderlies approach Andrew/Teddy as he says "Yeah, we are aren't we?"
The ending of the novel is unclear as to which "reality" is true. It is unclear whether he has truly regressed, or if he wishes to "die" (at the very least, lose his ability for conscious thought, through lobotomy) in order to avoid living with the knowledge that his wife murdered their children and he is her murderer.