This episode centers around a girl named Clara, who just moved to the Enterprise with her father. She is lonely, and creates an imaginary friend named Isabella to keep her company. One day, to her surprise, her imaginary friend appears, and seems real.
Clara and Isabella spend all their time together. Increasingly, Isabella gets Clara into trouble by leading her into off-limits places. (Isabella always makes herself invisible before adults see her.) Eventually Isabella gets Clara into enough trouble that Clara leaves her friend alone to go play with others. When she returns, Isabella is angry and says, "When the others get here, you can die like everyone else."
Clara works up the courage to talk to her father, who then talks to Captain Picard. The crew learns that Isabella is actually an energy-based life form whose home is the nebula outside the ship. (The ship has been exploring a rare nebula that formed around a neutron star.)
Picard finds Isabella in the arboretum and talks to her about human parenting. Isabella argues that the adults were cruel to Clara, and Picard explains that rules are for her protection. Isabella is convinced, and allows the ship to pass safely through the nebula.