Nigeria now has the world's third largest film industry after Hollywood and Bollywood. Most of the movies are dirt cheap, straight-to-video voodoo horror flicks - but millions of fans can't get enough of them. Jeevan Vasagar reports from Lagos

It is late afternoon, and the crew and cast of a film called American Dream are on location in an office block in suburban Lagos. An office here, borrowed for the day, is doubling as a flashy advertising agency, and on set the male lead is busy ironing his pink shirt on a desk, while the producer is shouting for the props man. The crew was meant to have wrapped these scenes up by midday and the director, Tony Abulu, is anxious. "We don't have much time," he says. "We've only got an hour and then we have to get out of here."

In a country where movies are made on shoestring budgets and cracked out in an average of 10 days, slips in the schedule can be disastrous.

In response to the producer's hollering, a man in flip-flops staggers into the room beneath a giant plant pot. Another member of the crew brings in a flat-screen computer. The scene is set and the cameras can roll.

Nigeria is home to one of the world's youngest film industries, but it's booming. In just 13 years it has gone from nothing to estimated earnings of US$200m (£114m) a year - making it the world's third biggest film industry after that of America and India. The films are made on the cheap, but they are big box office.

Except that there is no box office, of course. In Nollywood, as it has inevitably been dubbed, movies are shot on video and copied straight on to tapes or DVDs and then sold on from thousands of street stalls and hole-in-the-wall shops, not just in Nigeria but across the continent, as well to the African diaspora via markets in the west.

"They sell a lot of our films in Peckham and in Dalston market [in London]," says Paul Obazele, the veteran producer on American Dream, who has already turned out four movies this year, and plans a US cinema opening for this latest effort. "But Peckham is becoming too small for us. We have decided to take on the world."

There are signs that the world is taking an interest - the Hollywood actor Wesley Snipes came to check out investment opportunities last September. You might argue that Nollywood needs to do something about its hackneyed plots, hammy acting and appalling sound quality if it's to become a real rival to Hollywood. But for African audiences, Nollywood films have one unique selling point. If Hollywood's forte is jaw-dropping spectacle and Bollywood's is heart-warming musical slush, then Nollywood's special draw is a genre that might be described as the voodoo horror flick: films that revolve around witchcraft and demonic possession.

Most observers agree that it all began in 1992, with Living in Bondage, a cautionary tale about a man who gets sucked into a cult that demands the sacrifice of his wife in exchange for riches. The title refers to spiritual rather than sexual bondage. Since then, the genre has gone from strength to strength.

The movies can be read as fantasies; they allow the powerless to feel vicariously powerful. The stories tell of poor men getting rich, of errant husbands who find their penises shrinking, of love rivals who go blind or crazy and end up running naked and shrieking into the streets.

There is the occasional humorous twist. One classic features a controlling girlfriend who miniaturises her man and traps him inside a bottle. But the films always end with the practitioners of witchcraft being punished (although sometimes they are redeemed by finding Jesus) and the virtuous being rewarded. One of the reasons this is such a powerful draw is that in Nigeria, as elsewhere in Africa, Christianity lies like a veneer over much older beliefs. The occult movies give people a chance to thrill once again to the power of the old religion, but then celebrate the victory of the new faith as the credits roll.

"The average human being wants to see that which is hidden," says Okechukwu Ogunjiofor, producer of Living in Bondage. "But we didn't glamorise it. We made people sit down and think, and opened up their minds. After that film came out, a lot of people left these [witchcraft] cults."

The power of the genre is evident during a visit to one of Nigeria's improvised backstreet cinemas. The cinema is essentially a grimy concrete shelter with a billygoat tied up by the door. Inside, a dozen or so men and women are watching a Nollywood video on a small TV.

The crowd sway and click their fingers during musical interludes, and giggle and shove each other during comic passages. But they watch enthralled when a woman in the grip of an occult mania is exorcised by a man in a giant blue turban and flowing robe.

Back on the set of American Dream, the make-up artist, Benjamin Ejimnkeonye, finishes powdering the noses of two mountainous henchmen and passes around photos from voodoo thrillers he has worked on.

One of the pictures shows women made up as witches, their hair wild, white clay smeared on their faces and circles of red lipstick around their lips and eyes. "I like occultic films," says Ejimnkeonye, who goes by the trade-name Oben Imaginations. "When you watch an occultic film, you wonder, wow, is that really happening? That's when I like my job."

Not all Nollywood movies are about the occult, of course. Nigeria is a country of startling inequality; in Lagos, skinny fishermen in pirogues skim past the skyscrapers of Victoria Island, the palm-studded local equivalent of Manhattan, and slums sprawl under flyovers. But as is true of Bollywood, Nollywood likes to eschew the grit of everyday life for a more upbeat vision.

As well as occult movies, and gangster movies, another popular genre involves straightforwardly aspirational tales. American Dream is typical. it's the story of a driven advertising executive who falls in love with an American woman and then jeopardises his high-flying career with increasingly desperate attempts to get a visa for America.

In the movies, characters are always dashing from the gym to the boardroom in chauffeur-driven cars, or ordering champagne in chic restaurants. Budgets usually dictate that the champagne bottle isn't actually shown - film budgets typically range from £9,000 to £22,000, which means that star names only earn between £1,100 and £1,800 a film - but none the less, the movies generally manage to give an impression of glamour.

On the shoot, there are more delays. The cast and crew are waiting for one of the lead actors who is hours late. As some of the actors swig Guinness in the sweltering heat, I talk to Segun Arinze, a portly veteran actor who has a key role in the scene to be shot today. "Nigerian producers and directors want to put people in a certain kind of role," Arinze says. "Everybody knows me as the 'bad boy', always with the gun." He cocks his fingers into a pistol shape. "This is different because I get to play the father figure here, the dad.

"I see myself as a Method actor," he adds.

A short while later, however, with impeccable professionalism, Arinze is cheerfully swaggering through an entirely different role - as an underworld loan shark. With this last-minute switch, there has been no time to learn his lines, and barely minutes to get into character. Most of his dialogue is improvised.

Such fluidity is commonplace. With little time to rehearse, the actors frequently read from scripts left open on the floor during filming and most of the emphasis is placed on moving the plot forwards. Nollywood directors are sanguine about long passages of improvisation, and the dialogue that results is a clunky and sometimes bizarre mix of western movie cliches and Nigerian references. Take, for example, the following fragment of dialogue from a film about a chieftain's son who is forbidden by his family to marry his girlfriend:

He: My love for you cannot break, but the people and gods of my land want me to break it.

She [in floods of tears]: They want you to send me away.

He: Angel, don't cry. Let's try to find a solution to this problem.

[Moment later, after he has tried to bribe her to break off the relationship ... ]

She: You want to pay me in exchange for the love I have for you? Oh God, how did I get myself into this mess? Have you forgotten our promises and dreams?

Nigeria has perhaps the most distinguished literary tradition in Africa; Chinua Achebe, Wole Soyinka, Ben Okri and Ken Saro-Wiwa are the best-known writers, but it is clear that Nigeria's home video industry has no pretensions to high art. What it's all about is money. Nollywood movies were originally financed by importers of blank video tapes as a way of promoting sales of their product - and commerce remains king.

About 30 new titles arrive weekly at Lagos's giant open-air markets, where canvas banners with gaudy portraits of movie stars flap above the mediaeval hubbub. A new movie costs the equivalent of £1.80 to buy, and only about 27p to rent from a video club.

For the most part, Nigerians are proud of their movie industry and other African nations are envious. "I think there's a lot of things that converge to make this possible in Nigeria," says Femi Odugbemi, president of the Independent Television Producers' Association. "By tradition, we're a storytelling people. We have more than 230 languages, different cultures, all unique in themselves."

Nigeria is an African giant - it is the continent's most populous nation, with 133 million people. But it's also a country that appears to be constantly on the verge of a breakdown.

It is a British colonial creation, knitting together a Christian south and Muslim north, scores of ethnic groups and struggling to deal with festering discontent in the oil-rich delta region. That makes the film censor's job a tricky one.

"Sometimes we have movies that caricature certain ethnic groups - which say that Igbos are only looking for money, or that people up north are not very educated," says Emeka Mba, director-general of the National Film and Video Censors Board. "Depending on the context, that can be passed, as long as the entire movie is not about that theme."

Lagos, the commercial capital, is a microcosm of Nigeria's volatile mix. It is a monster: already home to 15 million and growing so fast that by 2010 the UN estimates it will be home to as many as 24 million, making it the third biggest city in the world. There is a sense of natural theatre on the streets of the city; even asking for directions leads to raised voices and urgent hand signals.

"We have a very expressive culture, and that affects our acting," says Richard Mofe Damijo, a broad-shouldered actor with a greying goatee. A popular romantic lead, he is sometimes described as "the Denzel of Nollywood".

"If I was working for a British director, I would play a lot calmer and internalise more. Here, the ability of an actor to portray emotion with tears is a plus. If you can't cry at the drop of a hat you're seen as a bad actor." Award plaques are stacked on the floor of Mofe Damijo's office; he has collected dozens in the course of a 40-movie career - Nollywood may be largely ignored by western film festivals, but it shows no hesitation in patting itself on the back.

On the American Dream shoot, filming has transferred to a poor quarter of Lagos, where the streets are lined with stained concrete houses with tin roofs, and chickens peck at rubbish heaps. A crowd gathers as the female lead, played by Maryam Basir, an African-American actor and model, teeters across a narrow wooden footbridge wearing a zebra-print summer dress and stacked heels.

The male lead, Nigerian actor Karibi Fubara, is being filmed making a long-distance call to his girlfriend at a public booth, a wooden table where a handset offers a crackly connection.

When his allotted time runs out he tries to hang on to the phone, squeezing in a few extra seconds and ignoring the impatient queue behind. This is the cue for a female extra in a luminous green dress to seize the handset and berate him with a string of Hausa swearwords.

The woman's tirade mingles with the hoots of a watching crowd of small boys and the growl of passing motorbike taxis. Almost miraculously, the production seems to be somehow coming together.

"Nollywood is only 13 years old," says Ogunjiofor, producer of Living in Bondage, who is now making TV soap operas, as well as preaching as an evangelical pastor. "If it's a child, it's not yet an adolescent. Wait until we're an adult, and then those who criticise us will come back and learn from us."