The Good Terrorist is written in third person from the point of view of Alice, an unemployed politics and economics graduate in her mid-thirties who drifts from commune to commune. She considers herself a revolutionary, fighting against "fascist imperialism", but is still dependent on her parents, whom she treats with contempt. In the early-1980s, Alice joins a squat of like-minded "comrades" in a derelict house in London. Accompanying her is Jasper, a graduate she took in at a student commune she lived in fifteen years previously. Jasper became dependent on Alice and followed her from squat to squat. Alice fell in love with him, only to become frustrated later by his aloofness and bourgeoning homosexuality. Other members of the squat include Bert, their ineffective leader, and a lesbian couple, the maternal Roberta, and Faye, her unstable and fragile partner.
The abandoned house is in a state of disrepair and is earmarked by the City Council for demolition. To the indifference of the other comrades, Alice takes it upon herself to clean up and renovate the house, and convinces the Council that it is worth saving. She also persuades the authorities to restore the electricity and water supplies. Alice becomes the house's "mother", cooking for everyone, and dealing with the local police, who are trying to evict them. The members of the squat belong to the Communist Centre Union (CCU), and attend demonstrations and pickets. Alice involves herself in some of these activities, but spends most of her time working on the house.
To be more useful to the struggle, Jasper and Bert travel to Ireland to persuade the Irish Republican Army (IRA) to let the CCU join them, but they are rejected. They also take a trip to the Soviet Union to offer their services, but are turned down. The IRA and KGB, however, have begun taking notice of them and start using the house as a conduit for propaganda material and guns. Packages start arriving in the middle of the night, and Alice, to avoid attracting the attention of the police, raises objections. This results in visits to the house by strangers who question the squat's decision making. After this, the comrades decide to ignore orders, to act on their own, and to consider themselves "Freeborn British Communists".
Going it alone now, they start experimenting with explosives, and build a car bomb. Alice does not fully support this action, but accepts the majority decision. They target an upmarket hotel in Knightsbridge, but their inexperience results in the premature detonation of the bomb, which kills Faye and several passers-by. The remaining comrades, shaken by what they have done, decide to leave the squat and go their own way. Alice, disillusioned by Jasper, chooses not to follow him and remains behind because she cannot bear to abandon the house she has put so much effort into. Despite her initial reservations about the bombing, Alice feels a need to justify their actions to others, but realises it would be fruitless because "[o]rdinary people simply didn't understand". She acknowledges that she is a terrorist now, though she cannot remember when the change happened.