Segismund is back in his dungeon in the tower, with Clotaldo. They are talking of what happened at court, but Segismund is adamant that these events really occurred, while Clotaldo assures him that he was dreaming. Segismund points out that Clotaldo appeared in this “dream” looking just as he does now, but Clotaldo replies that the false spirits who send dreams to delude people often add some truth to make the illusion more convincing. He adds that dreams are often motivated by the ambitions of the dreamer: nothing is more natural for a prisoner than to dream of being a prince.

Segismund remembers that just before his “dream” ended, King Basilio warned him to beware, in case everything he thought was real should turn out to be a dream. Clotaldo says that such references to dreaming are another peculiarity of dreams. He then points out that perhaps it is just as well that the situation Segismund describes was only a dream, since Segismund does not seem to have behaved well in it. Segismund decides to go to sleep again and try to recapture the dream he recalls so vividly.

Segismund departs to sleep, and Fife arrives, asking after Rosaura, whom she keeps calling her mistress by mistake, forgetting that she is disguised as a man. Clotaldo dismisses Fife’s concerns impatiently and leaves. Fife discerns a captain approaching at the head of a troop of soldiers, and hides. It becomes clear from the dialogue between the captain and the soldiers that they are seeking the tower where Segismund is imprisoned. They see the tower and then discover Fife. At first they are about to kill her, but then it occurs to them that she may be the prince. Fife assures them that she is not the prince of Poland, but only a poor boy from Muscovy, whereupon they think she may be a spy for Duke Astolfo.

One of the soldiers reports that Clotaldo has fled and Prince Segismund is inside the tower, fast asleep. The soldiers bring Segismund, still sleeping, out of the tower and set him down in the middle of the stage. They surround him, kneeling, and wake him by playing their trumpets and drums. The captain proclaims that he and his soldiers are loyal to Segismund, the true heir to the crown of Poland, and will fight for him against Basilio, who now intends to name Astolfo as his successor.

Segismund appears to think that he is dreaming again. This dream is much like the last one: he is not in a palace now, but again he is being acclaimed as a prince. He asks the captain and soldiers not to mock him in this way. The captain protests that, now the people and the army are aware of his existence, many are rallying to his cause, but Segismund does not believe him and again asks the soldiers to leave him.

As the captain argues with Segismund, he hears the sound of King Basilio’s forces bearing down upon them. Rosaura enters and tells Segismund that this is the third time they have met, since she was at court when he was proclaimed a prince. She also reveals that she is a woman and was betrothed to Astolfo before he came to Poland, seeking the throne and Princess Estrella with it. Her presence moves Segismund to action, and he decides to join battle against Basilio’s troops, though he is still unsure whether he is dreaming or not.

The captain announces that Clotaldo has been captured, and the soldiers bring him in. Segismund is about to kill Clotaldo with his sword when he considers again the possibility that he is dreaming. He orders that Clotaldo be given his sword and a fresh horse, and allowed to return to the king. A battle then takes place between the troops loyal to Segismund and those who support Basilio.