Six months after the chaotic events of Batman: Arkham Asylum, both the Elizabeth Arkham Asylum for the Criminally Insane and Blackgate Prison remain gutted, the former in a massive breakout launched by the inmates, lead by the Joker and the latter due to a mysterious fire, which the Joker hints was caused by him for his plans in Arkham Asylum. The administrator of Arkham, mayoral candidate Quincy Sharp, soon takes advantage of Batman's defeat of the Joker at Arkham and claims the credit himself for bringing the asylum back under control, perhaps saying Batman was working under his orders. This is partially to salvage his image, in tatters after the single worst asylum riot took place at a crucial time when Sharp was trying to convince the people of Gotham City to vote for him.
This is successful, and Sharp is elected mayor of Gotham (though it's actually thanks to Hugo Strange's partnership with Ra's al Ghul). His first act is to announce ruined Arkham Asylum and Blackgate Prison both unfit to house criminals, sane or insane. He then undertakes a bold new project: To move all the former inmates of incarceration at both places into a walled-off urban district, Arkham City. This will be a city only for villains, and is made up of Gotham City's most notorious slums, including Crime Alley. To guard the perimeter of Arkham City the mayor does away with Arkham Asylum's old security force and replaces them with professional mercenaries from a private military organization, TYGER (who are subjugated to brainwashing by Strange). Once all the criminals are trapped inside the prison city, they are told they may do as they please, but there is only one rule: Do not try escaping or you'll be shot dead. This is supported by the TYGER mercenary forces, who enforce this policy through the liberal use of their firearms on any escaping denizens of Arkham City. Since the entire population of Arkham is made up of criminals running wild on the streets, Sharp secretly hopes they will destroy each other inside walled confinement instead of committing crimes in Gotham.
With the criminals free to do whatever they want short of escaping, bloody turf wars erupt as various super-villains carve up Arkham City among themselves. A mysterious figure named Dr. Hugo Strange, an Arkham psychiatrist, is placed at the helm of the project by Sharp, but little is known about his objectives or his shadowy past, and rumors soon run rampant that he is up to horrible things behind Arkham City's walls. Those who try and find out too much about Arkham or Strange one by one mysteriously vanish by night, and it is implied most end up inside the city themselves, to be torn apart by the inmates. Batman, wary of Sharp and even more so of Strange, monitors Arkham City for several months, believing that the entire thing has been a ticking time bomb waiting to explode.