Iolanthe rises from the stream that has been her home in exile, and is surrounded by her former friends. She tells them of her son, the half-fairy, half-mortal Strephon. When her friends finally depart, Iolanthe meets Strephon, and hears from him of his love for the Lord Chancellor's current ward, Phyllis. Strephon is despondent, as the Lord Chancellor has forbidden them to marry -- partly because he himself wishes to marry Phyllis. Iolanthe promises to help her son, in part by arranging for him to become a Member of Parliament. Phyllis comes by, and she and Strephon share a moment of tenderness.
As they leave, a cadre of the peers of the realm arrive. They are all, it turns out, in love with Phyllis, and appeal to the Lord Chancellor to settle the matter. They send for Phyllis, who declares that she won't marry anyone but Strephon. The Peers immediately separate the two lovers. Strephon calls on Iolanthe for help; she appears, and in her affection for her son, the Peers see an opportunity. They tell Phyllis that Strephon is being affectionate with an (apparently) young woman, and scoff at claims that Iolanthe is Strephon's mother. Phyllis is convinced, and rejects Strephon for this "infidelity". Strephon calls for help from the fairies and they appear but are mistaken by the Peers for a girls' school on an outing. Enraged, the faries pronounce a curse on the peers: Strephon shall not only join their number, but will be able to get any bill he proposes passed. He is to be the instrument of fairy vengeance, disrupting Parliament and causing trouble.
This revelation triggers a flood of changes of heart. The Lord Chancellor is delighted to find his beloved wife once again. Phyllis finally believes that Iolanthe is Strephon's mother, and is reunited with him. The rejected Peers are impelled look elsewhere for brides. The Fairy Queen, on the other hand, is not happy, and appears to punish Iolanthe for betraying the condition of her pardon by returning to her husband. She is somewhat shocked when the rest of the fairies inform her that they've chosen husbands among the peers themselves. The Lord Chancellor suggests a solution: change the law so that fairies must marry mortals. The Fairy Queen agrees, proposes to her beloved Private Willis, and presumably they all live happily ever after.
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