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In October 1998, IGN reported, based on an interview with affiliate Voodoo Extreme, that Sweeney was doing research for his next-generation engine. With development starting a year later, the second version made its debut in 2002 with America's Army, a free multiplayer shooter developed by the U.S. Army as a recruitment device. Soon after, Epic would release Unreal Championship on the Xbox, one of the first games to utilize Microsoft's Xbox Live.

Though based on its predecessor, this generation saw a notable advance in rendering terms as well as new improvements to the tool set. Capable of running levels nearly 100 times more detailed than those found in Unreal, the engine integrated a variety of features, including a cinematic editing tool, particle systems, export plug-ins for 3D Studio Max and Maya, and a skeletal animation system first showcased in the PlayStation 2 version of Unreal Tournament. In addition, the user interface for UnrealEd was rewritten in C++ using the wxWidgets toolkit, which Sweeney said was the "best thing available" at the time.

Epic used the Karma physics engine, a third-party software from UK-based studio Math Engine, to drive the physical simulations such as ragdoll player collisions and arbitrary rigid body dynamics. With Unreal Tournament 2004, vehicle-based gameplay was successfully implemented, enabling large-scale combat. While Unreal Tournament 2003 had support for vehicle physics through the Karma engine, as demonstrated by a testmap with a "hastily-constructed vehicle", it wasn't until Psyonix created a modification out of Epic's base code that the game received fully coded vehicles. Impressed by their efforts, Epic decided to include it in its successor as a new game mode under the name Onslaught by hiring Psyonix as a contractor. Psyonix would later develop Rocket League before being acquired by Epic in 2019.

A specialized version of UE2 called UE2X was designed for Unreal Championship 2: The Liandri Conflict on the original Xbox platform, featuring optimizations specific to that console. In March 2011, Ubisoft Montreal revealed that UE2 was successfully running on the Nintendo 3DS via Tom Clancy's Splinter Cell 3D. "The 3DS is powerful, and we are able to run the Unreal Engine on this console, which is pretty impressive for a handheld machine, and the 3D doesn't affect the performance (thanks to my amazing programmers)," said Ubisoft.

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