Sir Andrew considers leaving because Olivia favours Cesario. Sir Toby talks him into challenging Cesario to a duel. Maria reports Malvolio is on his way to Olivia in yellow stockings.
Sir Andrew is convinced: Olivia clearly prefers Cesario over him. He watched her shower attentions on the young man and he saw enough. He wants to leave Illyria. Sir Toby and Fabian work to keep him. They tell him Olivia was only paying attention to Cesario to make Sir Andrew jealous: she wanted to provoke him to some courageous or impressive act to prove his worth. All he needs to do is challenge Cesario to a duel.
Sir Andrew is persuaded and goes to write his letter of challenge. Sir Toby announces he will not actually deliver the letter; he will improvise a verbal challenge instead, to produce maximum comic effect.
Maria arrives with news: Malvolio has followed the letter's instructions. He is on his way to Olivia in yellow stockings, cross-gartered, smiling constantly. The conspirators are delighted and hurry to watch.
The scene is the comic subplot's transitional moment. It sets up two colliding threads for Act 3, Scene 4: the duel farce and Malvolio's presentation to Olivia. Both will arrive in the same scene and both will go wrong simultaneously.
Sir Toby's handling of Sir Andrew here is the subplot's clearest demonstration of his real character. He is not simply a jolly rogue enjoying disorder; he is a calculated manipulator of someone poorer in wit and richer in money than himself. The explanation he offers Andrew, that Olivia was testing him with jealousy, has no basis in what the audience observed in the previous scene. Sir Toby invents it because it keeps Andrew in play.
Fabian's simile at this point is one of the play's most vivid comic images. He tells Andrew he has "sailed into the north of my lady's opinion, where you will hang like an icicle on a Dutchman's beard." The image is precise: Andrew's position with Olivia is frozen, exposed, and ornamental at best. The suggestion that a duel might thaw things is absurd, but Andrew does not notice.
Sir Toby's decision not to deliver the written challenge properly is important for the scene that follows. He prefers to improvise a verbal version, which will allow him to exaggerate both fighters' reputations in real time. He wants the maximum comedy, not the minimum violence. The duel was never going to be about justice or valour; it was always going to be entertainment for Sir Toby.