The Good Terrorist is written in the subjective third person from the point of view of Alice, an unemployed politics and economics graduate in her mid-thirties who drifts from commune to commune. She is trailed by Jasper, a graduate she took in at a student commune she lived in fifteen years previously, who sponges off her. Alice fell in love with him, only to become frustrated by his aloofness and burgeoning homosexuality. She considers herself a revolutionary, fighting against "fascist imperialism", but is still dependent on her parents, whom she treats with contempt. In the early 1980s, Alice joins a squat of like-minded "comrades" in a derelict house in London. Other members of the squat include Bert, its ineffective leader, and a lesbian couple, the maternal Roberta and her unstable and fragile partner Faye.
The abandoned house is in a state of disrepair and earmarked by the City Council for demolition. In the face of the indifference of her comrades, Alice takes it upon herself to clean up and renovate the house. She also persuades the authorities to restore the electricity and water supplies. Alice becomes the house's "mother", cooking for everyone, and dealing with the local police, who are trying to evict them. The members of the squat belong to the Communist Centre Union (CCU), and attend demonstrations and pickets. Alice involves herself in some of these activities, but spends most of her time working on the house.
To be more useful to the struggle, Jasper and Bert travel to Ireland and the Soviet Union to offer their services to the Irish Republican Army (IRA) and the KGB, but are turned down. A more organised group of revolutionaries moves in next door and start using Alice's house as a conduit for arms, to which Alice objects. Mysterious strangers visit the squat and question their decision making.
The comrades eventually decide to act on their own, calling themselves "Freeborn British Communists". They start experimenting with explosives and build a car bomb. Alice does not fully support this action, but accepts the majority decision. They target an upmarket hotel in Knightsbridge, but their inexperience results in the premature detonation of the bomb, which kills Faye and several passers-by. The remaining comrades, shaken by what they have done, decide to leave the squat and split up. Alice, disillusioned by Jasper, chooses not to follow him and remains behind because she cannot bear to abandon the house into which she has poured so much effort. Despite her initial reservations about the bombing, Alice feels a need to justify their actions to others, but realises it would be fruitless because "[o]rdinary people simply didn't understand". She acknowledges that she is a terrorist now, though she cannot remember when the change happened.