The next morning, Mutt goes to Lily's hometown with Billy, as he knows that Lily can help Mr. Conductor, but only if she meets someone special at Shining Time first. To reach that end, he directs her onto the wrong train, placing her on the train bound for Shining Time instead of Muffle Mountain. Meanwhile, Burnett Stone hears the sound of Lady's magic echoing through the mountain. the film's failure caused Allcroft to be leaving Gullane Entertainment in September 2000 and Peter Orton was in charge of Thomas in July 2001. Staring Peter Fonda, Mara Wilson (from Matilda) and Alec Baldwin (US Narrator of Thomas & Friends). Lily meets Stacy, who takes her to Burnett. That night, Burnett and Lily hear Lady's whistle coming from the mountains. Patch (who is outside with his horse) hears it too. The movie was filmed at the Strasburg Rail Road in Strasburg (Pennsylvania (United States)), as well as in Toronto (Ontario (Canada)) and on the Isle of Man. Castletown railway station on the Isle of Man Railway formed part of Shining Time Station and the goods shed at Port St Mary railway station became Burnett Stone's workshop. Running shots of the "Indian Valley Railroad" train were filmed at the Strasburg Rail Road location. The large passenger station where Lily boards the train is the Harrisburg Transportation Center. Norfolk & Western 475' was repainted as the Indian Valley locomotive. Sodor was realised using models and chroma key. The models were animated using live action remote control, as on the television series. The model sequences were filmed in Toronto instead of Shepperton Studios, the "home" of the original TV show; however, several of the show's key staff were flown over to participate. The Magic Railway was created using models, CGI and water-coloured matte paintings.

Later that night, Mr. Conductor has a nightmare of Shining Time in ruins and realises that his universe is in danger and that he needs more gold dust. At Knapford, Mr. Conductor reads the note Sir Topham Hatt left him. After trying on his top hat (and returning it after he notices the portrait of the Controller appears angry) he receives a phone call from Sir Topham Hatt and receives his instructions. The chase finally approaches the Viaduct. As Lady and Burnett pass, a gap appears on the viaduct. When Thomas manages to make it across the gap before it worsens, Diesel 10 cannot stop in time and falls off into a sludge barge and is towed away, not to be seen for a long-long time.After seeing Billy Twofeathers' map and noticing some strange lines on it, a boy from Shining Time named Patch heads off to Muffle Mountain to see Burnett Stone. In February 1996, Britt Allcroft was approached by Barry London with an idea for the Thomas film. Britt signed a contract to write the script for the film with the working title Thomas and the Magic Railroad. London's interest is thought to have stemmed from his 3-year-old daughter, who was enthralled by Thomas. Filming (according to a press release) was to take place at Shepperton Studios, in the United Kingdom and the United States, with the theatrical release date set for 1997. However, Paramount shelved the plans for the film after London left the company later that year. This left Allcroft to seek other sources of funding. Discussions with PolyGram about the film were held, but not for long because of the company being in the middle of a corporate restructuring and sale. While Diesel 10 starts to give chase, Splatter and Dodge (fed up with Diesel 10's ways) abandon him. Thomas offers to help Lady, with Burnett driving Lady. Mr. Conductor warns them about the collapsing viaduct. Just as the engines run away, the conductors realise that Lady is part of the clue to the gold dust. Thomas, Lady and Burnett return, where they and the rest of the team work out the answer to the riddle. Lily mixes water from the well with golden shavings from the magic railroad and with a little encouragement, tosses them into the air, where they form into gold dust. Delighted, the conductors resupply their whistles, while Thomas thanks Lady.

Mr. Conductor goes to the windmill in search of more gold dust, but gets lost. Meanwhile, the engines gather for a meeting. As Bertie passes by and tells them to smile, all have their individual concerns. Thomas heads off to look for Mr. Conductor, apologising to Bertie when he is unable to accept Bertie's offer for a race. Released on DVD and VHS in the UK in 2000 by Warner Home Video, Icon Home Entertainment, Destination Films, Gullane Pictures, Britt Allcroft and The Magic Railroad Company. Burnett looks at a painting of Lady and starts to have doubts in his belief of magic due to his failure to guard her. Meanwhile, far away, Burnett's granddaughter (Lily) prepares to visit him. Thomas and the Magic Railroad was released onto VHS and DVD on October 19, 2000 in the United Kingdom by Icon Productions, in the United States on October 31, 2000 by Columbia TriStar Home Entertainment and in Australia on April 2, 2001 by ABC Video. Thomas is later talking to James at Tidmouth Sheds when Diesel 10 shows up and voices his plan to destroy a lost engine named Lady and thus establish Diesels as the dominant engines on Sodor. While James is confused, Thomas is worried and goes to find Mr. Conductor.Mr. Conductor and Lily camp out with Thomas. After a conversation, they realise that Burnett may hold the key to the clue of the gold dust. There is something on Muffle Mountain, a secret that Burnett only shared with his childhood friend and future wife Tasha: he promised he would drive an engine and take her with him. When Patch sees the engine, Burnett reveals the engine's past - her name is Lady since she was sealed inside Muffle Mountain since Diesel 10 nearly destroyed her long ago. Burnett has fixed her up, but informs Patch that she still needs coal to fully run again. Unfortunately, Lady requires special coal to build up steam, which he has not found yet.

Thomas, James and Gordon begin arguing about who should have taken Mr. Conductor, unaware that Splatter and Dodge are spying on them. Over in the yard, Splatter and Dodge are laughing at the steam engines. Henry tells the other engines about why Diesel 10 wants to find the lost engine. Splatter and Dodge continue to laugh at Thomas until Harold flies by, spreading sneezing powder, set up by Diesel 10, over all 3.