Second return to WWF (1994–1997)
Smith returned to the WWF at SummerSlam on August 29, 1994, where he immediately became involved in an ongoing family feud between Bret Hart and his brother, Owen Hart. Smith then teamed up with Bret against Owen and Jim Neidhart in a series of tag team matches, most notably in a victory on Monday Night Raw. On November 23, Smith appeared at Survivor Series in a 10-man elimination match; his partners were Intercontinental Champion Razor Ramon, 1-2-3 Kid, and The Headshrinkers. They faced WWF Tag Team Champions Shawn Michaels and Diesel, Owen Hart, Jeff Jarrett, and Jim Neidhart, but Smith was eventually counted out.
Smith again played a key part in the match at Survivor Series featuring his brothers-in-law Bret and Owen Hart, in which he supported Bret against Owen's benefactor, Bob Backlund. Smith was knocked unconscious by Owen, allowing Owen to take advantage of his brother's situation. Owen manipulated Bret's mother to surrender to Backlund on Bret's behalf, thus costing Bret to lose the match and the WWF Championship.
After entering the Royal Rumble as the second entrant on January 22, 1995, Smith and Shawn Michaels, who were the first entrants, were the final two remaining participants at the end. Smith tossed Michaels over the ropes and celebrated on the second turnbuckle. Only one of Michaels feet hit the floor and he was able to re-enter the ring and eliminate Smith from behind. Soon after, Smith began teaming with Lex Luger as the Allied Powers. On 2 April at WrestleMania XI, they defeated The Blu Brothers. At In Your House 2 on 23 July, they failed to win the Tag Team Championship from Owen Hart and Yokozuna.
Around this time, fans began getting tired of Smith being an English hero. At house shows, fans began chanting "USA, USA" which aggravated Smith. During a show at Madison Square Garden, The Allied Powers took on The Blu Brothers again, but before the match, Smith got on the microphone telling the fans to tone down the USA chant. They refused, and during the match, Smith walk out on Luger.
On an August episode of Monday Night Raw, the Allied Powers were supposed to face Men on a Mission, but Luger (kayfabe) no-showed the match; Smith found a replacement in the WWF Champion Diesel. During the match, Smith unexpectedly attacked Diesel and turned heel for the first time in his WWF career, helping Men on a Mission beat up Diesel and aligning himself with Jim Cornette's stable with Owen Hart and Yokozuna, who had been his adversaries just a month earlier, thus disbanding the Allied Powers.
Smith was to start a feud with Luger in a series of Flag Matches, but Luger returned to WCW and the feud was cancelled.
On 22 October at In Your House 4 in Winnipeg, Manitoba, Smith received a WWF Championship shot against Diesel, winning by disqualification after Bret Hart interfered. At Survivor Series on 19 November, Smith participated in the Wild Card eight-man elimination match, teaming with Shawn Michaels, Ahmed Johnson, and Sycho Sid and facing WWF Intercontinental Champion Razor Ramon, Dean Douglas, Owen Hart, and Yokozuna, which they won.
On 17 December at In Your House 5, Smith was granted a title shot against new WWF Champion Bret Hart, but was unsuccessful in winning. A notable incident from this match was that Hart bled during the match, which was controversial because WWF outlawed bleeding at the time. Smith entered the Royal Rumble on January 21, 1996, where he made it to the final four before being eliminated by Michaels. On 18 February at In Your House 6, he lost to Yokozuna by disqualification after Vader interfered. At WrestleMania XII on 31 March, he teamed with Vader and Owen Hart to defeat Yokozuna, Ahmed Johnson, and Jake Roberts.
In 1996, after Shawn Michaels became WWF Champion, Smith was put in a feud with the new champion. The feud was supposedly based on Smith's wife, Diana, accusing Michaels of hitting on her, which angered Smith and made him determined to take the title from Michaels. The two were the main-event of the In Your House 8: Beware of Dog pay-per-view on 26 May, and their match ended in a draw, leading to a rematch on 23 June at King of the Ring, where Smith failed to win the title.
Afterwards, Smith formed a tag team with his brother-in-law, Owen Hart, and the two soon won the WWF Tag Team Championship from The Smokin' Gunns. The team defended their titles against teams such as Doug Furnas and Phil LaFon, Vader and Mankind, and The Legion of Doom. In 1997, the WWF created the WWF European Championship, and Smith became the first ever holder of the title, winning a tournament which culminated in him defeating his own tag team partner, Owen Hart, in the finals on 26 February.
Hart and Smith later joined forces with Bret Hart, Jim Neidhart, and Brian Pillman to form a new form of the Hart Foundation, a heel faction which feuded with Stone Cold Steve Austin and other American wrestlers. This created an interesting rift between American fans, where the Hart Foundation were vilified, and Canadian fans, who revered the Hart Foundation. Smith and Owen dropped the WWF Tag Team Championship to Austin and Michaels, and lost the final match in a tournament for the vacant WWF Tag Team Championship to Austin and Dude Love. Smith lost the European Championship to Shawn Michaels on 20 September at One Night Only.
Smith was booked in the main event to defend the belt against Michaels. Michaels convinced Vince McMahon that he should win, as it would create build-up for his impending rematch with Bret Hart, and for a rematch against Smith at the next British pay-per-view. Smith initially resisted, arguing that he had put Michaels over in all of their previous matches, and that since it was his hometown, he should be able to win. However, he eventually reluctantly agreed to put Michaels over, and fans at the event, who gave Smith an ovation, voiced their displeasure by viciously booing Michaels and littering the ring with garbage.
On 9 November at Survivor Series in Montreal, Smith was part of Team Canada (alongside Jim Neidhart, Doug Furnas and Philip Lafon), defeating Team USA (Vader, Goldust, Marc Mero and the debuting Steve Blackman). The event became infamous for the "Montreal Screwjob", in which Vince McMahon manipulated the finish of Bret Hart's match and had him lose the WWF Championship to Michaels, despite Hart not submitting when placed in a Sharpshooter. Smith then paid money to leave the WWF for WCW, along with Bret Hart and Neidhart, soon afterward.