Sebastian is alive and headed for Duke Orsino's court
Viola realizes that Olivia is in love with Cesario.
Maria, Sir Toby, Sir Andrew, Feste and Fabian are playing a trick on Malvolio, convincing him that Olivia is in love with him.
Viola's twin brother, Sebastian, is not dead! He is on the coast of Illyria and believing that Viola is dead, emotionally mourns her, blaming the stars. Antonio, the sea captain who saved him, brings Sebastian's mind to more practical matters and offers himself to be Sebastian's servant. Sebastian states that his destination is Duke Orsino's court and because Antonio has many enemies there, Sebastian cannot take Antonio. Antonio acknowledges the danger and decided to go anyway.
Malvolio finds Cesario and delivers Olivia's ring to him, sarcastically reprimanding him for being so absent-minded. Left alone, Viola realizes that Olivia has fallen in love with Cesario. A tangled knot indeed! Viola is in love with Orsino, who is in love with Olivia, who in turn is in love with Cesario (Viola). Viola calls upon Time to untangle the knot, for "it is too hard a knot for me to untie."
Meanwhile, back at Olivia's house, Sir Toby and Sir Andrew have been drinking (reveling) and are noisily celebrating. The clown, Feste, joins them and they all begin singing loudly together. Maria also comes and warns them that if they don't settle down, Olivia will send Malvolio to kick them out. Malvolio soon shows up and scolds Toby and Andrew. When Toby and Feste begin to mock Malvolio, Malvolio quickly turns on Maria, reprimanding her for allowing such behavior and warning her that he will report her to Lady Olivia. Maria devises a plan to get even with Malvolio--she will forge a love letter to Malvolio from Olivia.
Cesario and Duke Orsino talk about love. Orsino says that woman cannot love as truly as man. Cesario disagrees and tells Orsino that her father had a daughter who loved a man with as much passion as Cesario could have for Orsino--if Cesario were a woman, that is. The Duke asks Cesario to continue the story, Cesario says that his "sister" loved so purely, passionately, and privately that she died; although men may talk more and swear more, talk is often empty. Orsino gives Cesario a jewel to present to Olivia and Cesario is not to take "No" for an answer from Olivia.
Malvolio finds the letter and assumes that it is written of him. It declares Olivia's love for him and that to please her Malvolio should wear yellow stockings, cross-garters, be "surly" with the servants, and smile continuously; Malvolio leaves to carry out the terms of the letter. Toby, Andrew, and Fabian come out from where they were spying as Maria enters. Toby says that he is prepared to marry Maria for her cleverness. Maria mentions that Olivia detests yellow stockings and cross-garters and Olivia is so melancholy that Malvolio's smiling will drive her into a fury.