In her garden, Olivia consults with Maria on how best to woo Cesario, who has agreed to come back yet again. She asks Maria to bring Malvolio to advise her, as his melancholy mood will better match her own. Maria replies that Malvolio seems to have gone mad, for he does nothing but smile. Sending Maria off to fetch him, Olivia remarks that she herself feels just "as mad as he, if sad and merry madness equals be" (3.4.14-5).
Olivia's continued obsession with Cesario, and her private remark that she is suffering from "sad and merry madness," show her love-melancholy approaching the intensity of Orsino's—and perhaps even exceeding it.
Malvolio enters wearing yellow cross-gartered stockings, smiling idiotically. Olivia scolds him for this behavior. However, he continues grinning and alluding to the letter which he believes she sent. Olivia concludes that Malvolio has fallen into "midsummer madness" (3.4.52). A servant enters, reporting that Cesario has returned. Olivia asks Maria to get Sir Toby to look after Malvolio. Then she goes to receive Cesario. Once Olivia and Maria are gone, Malvolio celebrates. He is convinced that his behavior has pleased Olivia and that now nothing can come between him and the "full prospect of [his] hopes" (3.4.76-7).
The servant/low and the noble/high plots start to come together, as they will continue to over the course of this scene. Malvolio, blinded by arrogance, totally fails to gauge Olivia's reactions—she obviously thinks he has gone crazy. Speaking of his love in terms of "prospects," Malvolio makes clear that he is still motivated most by a desire to boost his rank and wealth—that his love is really self-love.
Maria enters with Sir Toby and Fabian. All three pretend to be worried about Malvolio. Maria implies to Malvolio that he is acting crazily and reminds him that Olivia wanted him to remain in Sir Toby's care. Quickly losing patience, Malvolio dismisses the others as lower in rank than he, warns that they will hear more from him later, and storms off. Fabian comments that if their prank "were played upon a stage," he would dismiss it as "improbable" (3.4.119). Maria encourages them both to pursue Malvolio and continue to torment him. Sir Toby reports that Olivia already thinks that Malvolio is mad.
As Maria and the others continue to direct their prank in such a way as to make Malvolio seem mad, Fabian's remark that he wouldn't believe what he is seeing if it were performed on stage takes the theme of performance to the next level. In his grouchy threats, Malvolio both exhibits his usual snobbery and makes clear that he still believes Olivia will marry him, promoting and giving him power over the others.
Sir Andrew enters, holding the letter he has written to challenge Cesario to a duel. Sir Toby reads it, declares that it's sure to provoke Cesario, and offers to deliver it. When they learn from Maria that Cesario is at that moment visiting Olivia and is about to depart, Sir Toby convinces Sir Andrew to go lie in wait and swear at Cesario when he passes. Sir Andrew hurries off. Once alone with Fabian, Toby confides that he has no intention of delivering Sir Andrew's letter: Cesario is clearly too well bred even to acknowledge such a ridiculous challenge. Instead, Sir Toby will tell Cesario that Sir Andrew wants to fight, convince each of the other's dueling skills, and make each terrified of the other.
Like the prank on Malvolio, which provides an over-the-top parody of the way that lovers behave to win over their beloveds, this second comic subplot parodies another traditional love ritual—the duel. Like the prank on Malvolio, the duel will also be instrumental in bringing the high and low characters together. Toby is central to both plots. A noble who is more comfortable among the servants, he is a perfect agent of misrule, sowing chaos that will bring the high and low characters together.
Olivia enters with Cesario, apologizing for having said too much: she is so in love, she cannot help herself. Cesario reminds Olivia that his master, Orsino, is suffering just as she is. Olivia gives Cesario a locket containing her picture and promises that she won't deny Cesario anything he wishes. Cesario insists that he wants only for Olivia to reciprocate Orsino's love: she should transfer her feelings for Cesario to the Duke. Frustrated, but not defeated, Olivia bids Cesario farewell, reminding him to come the next day. She is so in love, she remarks, Cesario is almost like a "fiend" to bear her soul to "hell" (3.4.204). Olivia exits.
By staging this moment between the main characters as just a fleeting interruption of the low characters, Shakespeare inverts the priority of the two plots—a switch-up that echoes the switch-ups of servants and nobles that traditionally occurred during the Twelfth Night holiday. Falling deeper and deeper into the trouble caused by Cesario's disguise, Olivia seems desperately in love—she thinks she, like Malvolio, is really going mad.
Once Olivia has gone, Sir Toby and Fabian approach Cesario. Using all sorts of double entendre's about swords and sheathes, Sir Toby warns Cesario that a deadly assailant is waiting to attack him in the orchard. Baffled, Cesario asks Sir Toby to explain to this assailant that he did not mean to offend anyone. Sir Toby departs. Fabian picks up where Sir Toby left off, telling Cesario that the knight is the most dangerous in all Illyria. Cesario says he does not mind admitting that he's too cowardly to fight. Meanwhile, Sir Toby finds Sir Andrew and tells him that after receiving the (actually undelivered) letter, Cesario is furious and ready to duel. Fearful of what he has set in motion, Sir Andrew curses. As Sir Toby's prank comes to a head, Cesario remarks, in an aside, that he is so terrified he almost wants to confess that he is a woman to save himself.
The extensive exchanges between the various characters here draws out the metaphorical similarities between physical fighting and the "battle of the sexes" that has been going on (and conducted through messengers). It also goes on so long as to make the duel absolutely ridiculous. The dirty double entendres involving swords and sheathes draw attention to the fact that Viola has concealed her gender and that that is a problem: just as she cannot engage in the battle of love with Orsino, she cannot fight a man in a duel here.
Cesario and Sir Andrew approach each other and draw swords, terrified. At this instant, Antonio enters. Seeing Cesario—whom he thinks is Sebastian—he says that he will fight in Cesario's place. Sir Toby demands to know who Antonio is. Antonio replies that he is someone who in "his love dares yet do more" (3.4.297). Puzzled and irritated at this interruption, Sir Toby draws against Antonio.
Sir Toby, who is the "director" of this little "play-within-the-play" is irritated to have the events that he has set in motion interrupted. Once again, Antonio shows the deep devotion of his "love" for Sebastian, in contrast to the petty emotions that Sir Andrew expresses.
Suddenly, several officers appear. Sir Andrew and Cesario, overjoyed to stop fighting, put away their swords. The officers arrest Antonio, who asks Cesario—whom he still mistakes for Sebastian—to return the purse that he lent him. Cesario, confused but grateful for Antonio's help in the fight, offers him half of the money that he has on him. Dismayed, Antonio asks how the friend for whom he has done so much can deny him in his moment of need? Cesario replies that he doesn't know what Antonio is talking about, and that Antonio must be crazy.
Viola's disguise brings love-melancholy to her and Olivia. It also harms Antonio, who has given Sebastian honest and open friendship. The confusion that Viola's disguise causes—like the confusion that Maria, Sir Toby, and friends have deliberately caused Malvolio—starts to make Antonio seem mad to everyone around him.
As the officers pull him away, Antonio explains to them that he saved the life of this boy when he was drowning at sea. He shouts that "Sebastian" should be ashamed of himself. The officers drag Antonio off. Viola, meanwhile, is filled with sudden hope that her brother is still alive. She rushes off to search for him.
The outcome of the "duel" provides the first glimmer of the potential reuniting of Viola and Sebastian. Viola's excitement in running off to try to find Sebastian shows her deep devotion to her brother.
Once everyone has left, Sir Andrew vows that he will pursue and defeat Cesario. He runs off, with Sir Toby and Fabian following.
Sir Andrew continues to show ridiculous persistence.