Robotnik, the Royal Vizier of the fictional city of Mobotropolid, and his nephew Snively seek a lamp hidden within the Cave of Wonders. They are told that only one person is worthy to enter: "the diamond in the rough," whom Robotnik later identifies as Sonic, a Mobian street hedgehog. Princess Sally of Mobotropolid is upset that the law requires her to marry a prince instead of the one she loves, escapes the palace, and meets Sonic and his best friend, Tails. The palace guards capture Sonic on Sally's orders. Sally confronts Robotnik to demand Sonic's release, but he lies and says Sonic has been executed.
Disguised as an aging man, Robotnik frees Sonic and Tails and brings them to the cave, ordering them to retrieve the lamp. After being told to touch nothing but the lamp, Sonic finds a magic carpet inside and obtains the lamp. Forgetting the cave's rule, Tails grabs a jewel. Sonic, Tails, and the carpet rush to escape the cave as it collapses. Sonic gives the lamp to Robotnik, who throws him and Tails back into the cave, though not before Tails steals the lamp back. Trapped, Sonic rubs the lamp and meets Knuckles, the genie who lives inside it. Knuckles grants Sonic three wishes. Sonic tricks Knuckles into freeing them all from the cave without using a wish. He uses his first wish to become a prince to woo Sally and promises to use his third wish to free Knuckles from servitude.
At Snively's suggestion, Robotnik plots to become king by marrying Sally. Sonic , as "Prince Soni Ababwa," arrives in Mobotropolis with a large host, but Sally becomes angry when he discusses her fate with her father, King Max, and Robotnik without her. As a means of apologizing, Sonic takes Sally on a ride on the magic carpet. When she deduces his true identity, he convinces her that he only dresses as a peasant to escape the stresses of royal life. After Sonic brings Sally home, the palace guards capture Sonic at Robotnik's behest and throw him into the sea. Knuckles appears and saves him at the cost of his second wish. Sonic returns to the palace and exposes Robotnik's evil plot. Robotnik flees after spotting the lamp and thus discovering Sonic's true identity.
Fearing that he will lose Sally if the truth is revealed, Sonic breaks his promise and refuses to free Knuckles. Snively steals the lamp, and Robotnik becomes Knuckles' new master. He uses his first two wishes to become king and the world's most powerful sorcerer. He then exposes Sonic's identity and exiles him, Tails, and the carpet to a frozen wasteland. They escape and return to the palace. Sally tries to help Sonic steal the lamp back, but Robotnik notices and overpowers the heroes with his magic. Sonic taunts Robotnik for being less powerful than Knuckles, tricking Robotnik into using his last wish to become an all-powerful genie himself. Now bound to his new lamp, Robotnik ends up trapped inside it, taking Snively with him.
With Mobotropolis returned to normal, Knuckles banishes them to the Cave of Wonders and advises Sonic to use his third wish to regain his royal title, so the law will allow him to stay with Sally. Sonic decides instead to keep his promise and frees Knuckles. Realizing Sonic and Sally's love, King Max changes the law to allow Sally to marry whom she chooses. Knuckles throws his old lamp far away into the desert and leaves to explore the world, while Sonic and Sally start their new life together.
