The story is set in a small village near Banikhet, Himachal Pradesh and revolves around a young girl Biniya and village's only shop owner Nand Kishore Khatri. Biniya lives with her mother and elder brother. One day she comes across a blue colorJapanese umbrella while herding her family cows. The umbrella is revealed to be belonging to a group of Japanese tourists. Biniya develops a liking for the umbrella and trades it with her bear claw necklace called Yantra with the Japanese tourists. Wearing a bear claw necklace is considered to be auspicious and bring good luck. For that she is scolded by her mother. Everyone in the village is amazed by the beauty of the umbrella and Biniya acquires a celebrity like status. This makes some people jealous of her. The shopkeeper Khatri and Lillavati covet for such an umbrella but find themselves unable to buy due to its high cost. Lillavati even hints toward the possibility of stealing Biniya's umbrella. Khatri tries to buy it from Biniya but she refuses. Khatri's shop boy Rajaram who in the past had stolen a tourist's jacket, offers Khatri his help in stealing the umbrella in exchange for increase in his salary. In a pasture, Binya finds her umbrella missing and becomes heartbroken. Later she accuses Khatri of stealing it. Khatri's shop is searched but no umbrella is found. Due to this humiliation, Khatri pledges to buy his own such umbrella. Soon after, Khatri gets a similar umbrella in red, which he claimed to have bought from Delhi. With this, the center of attraction shifts from Biniya to Khatri. As a gesture of good will to restore pride, the villagers nominate Khatri as the president of upcoming village wrestling competition. Biniya continue her investigation and finds that umbrella is actually sent by a textile dyer from a nearby town Banikhet. She accompanies the village policeman to Banikhet to find out the truth. At the same time, Khatri is presiding over the competition and it rains during his speech. The dye from the umbrella comes off and Khatri is revealed to be the thief. Due to his theft and lying, Khatri is boycotted by the village. Post boycott, Khatri's life becomes miserable as no one visit his shop. Even, Rajaram who was his accomplice abandons him. He is usually made fun of village people of passing school children. Biniya sympathies with Khatri and decides that Khatri is the real owner of umbrella not her. She gives the umbrella to Khatri and who is then accepted into the village
The Blue Umbrella received positive reviews, including Hindustan Times writer Khalid Mohamed who describes it as a child's confection 'with passages of charm, visual aplomb and lively performances.' The acting of Pankaj Kapur is noted in particular.
