Set at the start of the twentieth century, the movie deals with the orphaned boy Álfgrímur, his adoptive grandparents, and the small, tolerant community of misfits and eccentrics they gather around them at Brekkukot, their cottage in Reykjavík. As Álfgrímur begins to encounter the minor politicians, businessmen and social-climbers of the growing town of Reykjavík he starts to question his future as a fisherman's grandson, and is increasingly fascinated by Garðar Hólm, the celebrated Icelandic "world singer" whose sporadic returns to Iceland encourage Álfgrímur to pursue his own personal goals of self-expression. He discovers the true value of his boyhood experiences only as he sets out on a path that will take him away from them forever.

"Síðasti bærinn í dalnum" is in the spirit of old folktales, a classic fairy tale about the struggle of good and evil. In the countryside, all the farmers have fled because of pestering trolls. One farmer, however, holds his ground with his family as the grandmother keeps a magic ring that protects the inhabitants from all evil. The trolls try to steal the ring and thus set in motion a series of events where forces of evil, a dwarf who can make himself invisible and an elf queen come to light.