WARNING: This page contains SPOILERS for Final Fantasy VII.
A lot of people seem to struggle with this part of the plot, so I have written a very brief summary of the most important details.
First, I suggest viewing (or reviewing if possible) the following things: The lifestream events, the letter on Tifa’s desk later in the game, the letter in Tifa’s piano when you get Final Heaven, the books in the back room of the Shinra Mansion Basement, the tubes in the main part of the basement lab, and the cutscene in the Shinra Mansion Basement once Cloud rejoins your group.
If you are still confused, missed some of these scenes, or are just too lazy to do it on your own, then read my half-assed explanation below:
(from the beginning)
Cloud was present in the Kalm flashback scenes. What he tells the party is actually Zack’s memories of the story. Cloud was simply one of the soldiers in blue. He’s with the group on the truck and is with them all the way to the reactor and back. When Sephiroth burns the town down, Cloud heads to the reactor. He finds Zack and Tifa already downed by Sephiroth (neither are dead yet). He grabs Zack's sword and proceeds to injure Sephiroth. As Sephiroth tries to leave, Cloud tries to stop him again. Sephiroth stabs him, but Cloud uses all of his strength and rage to grab the blade and chuck Sephiroth into the lifestream. He then (presumably) passes out. Shortly after this, Zangan arrives and takes Tifa to safety. Shinra soldiers and Hojo arrive before Zangan can save anyone else. Hojo takes Zack and Cloud (both still alive) to the Shinra Mansion basement. He apparently heals them. He then uses both of them for his experiments. Mako and Jenova cells are given to both Cloud and Zack. Zack has no discernable reaction to either. Cloud, however, has reactions. The experiments cause his mind to deteriorate (he becomes a vegetable).
Later, Zack manages to free himself and Cloud. Zack carries Cloud away from the mansion (and gives him his trademark clothes). They hitchhike on a truck to Midgar. When they are within sight of the city, Shinra troops find them. Zack is killed and Cloud is left to die (the troops see no point in killing a vegetable). Cloud staggers over and takes Zack’s sword. The rest is history.
Cloud’s memories are distorted due to the experiments. While they were together, Zack told Cloud about his experiences with Sephiroth and other things. Due to the poor condition of his mind, Cloud (with a little help from the Jenova cells and Mako poisoning) takes these memories as his own and actually starts to believe that he experienced parts of Zack’s memories.
Other notes: Hojo also gathered the fire survivors and used them for experiments. They become the black-cloaked figures you see in the game (commonly called Sephiroth ‘clones’). Yes, Nibelheim did burn down. Shinra rebuilt the town and hired actors to play the parts of the townspeople. This was an attempt to prevent anyone from ever knowing what really happened.
Is Cloud a Sephiroth Clone?
Yes and no. When the game uses the term "clone", it does not mean a genetically produced biological copy of a person. The term "Sephiroth Clone" simply means anyone who underwent Hojo's procedure of exposure to Mako and Jenova cells (the purpose of which was to test the Reunion theory, where all of Jenova's cells would try to reunite at one common location if separated). The survivors of the Nibelheim incident are all therefore categorized as Sephiroth Clones (they become the people in black cloaks), and so are Zack and Cloud (although Zack wasn't affected). This does not, however, mean that Cloud was "created" by Hojo. He was a real person, the same person that Tifa remembers growing up with.
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