The physical conditions in the inner narrow-line region (NLR) of the Seyfert 2 galaxy NGC 1068 are examined using ultraviolet and optical spectra and photoionization models. The spectra were taken with the Hubble Space T elescope Space Telescope Imaging Spectrograph (STIS), through the slit, 0A .1 ] 52A .0 covering the full STIS 1200È10000waveband. The slit was centered on a position north of the A 0A .14 optical continuum peak (or "" hot spot ÏÏ) at a position angle of 202¡, bisecting the brighter part of the biconical emission-line region. We have measured the emission-line Ñuxes for a region extending 3A .8 northeast (D270 pc) to southwest (D130 pc) of this point. The emission lines on each side show 1A .8 evidence of two principal kinematic components, one blueshifted with respect to the systemic velocity and the other redshifted (the kinematics were discussed in a separate paper). Based on the photoionization modeling results, we Ðnd that the physical conditions vary among these four quadrants. (1) The emission-line gas in the blueshifted northeast quadrant is photoionized by the hidden central source out to D100 pc, at which point we Ðnd evidence of another source of ionizing radiation, which may be due to fast (D1000 km s~1) shocks resulting from the interaction of the emission-line knots and the interstellar medium. Interestingly, this occurs at approximately the location where the knots begin to show signs of deceleration. (2) The gas in the redshifted northeast quadrant is photoionized by continuum radiation that has been heavily absorbed by gas within D30 pc of the central source. We Ðnd no strong evidence of the e †ects of shocks in this component. (3) The redshifted emission-line gas in the southwest quadrant is photoionized by unabsorbed continuum from the central source, similar to that in the inner D100 pc of the blueshifted northeast quadrant. Finally, (4) the emission-line spectrum of the blueshifted southwest quadrant appears to be the superposition of highly ionized, tenuous component within the ionization cone and gas outside the cone, the latter photoionized by scattered continuum radiation. There are several implications of this complicated physical scenario. First, the hidden active nucleus is the dominant source of ionizing radiation in the inner NLR. The absorption of continuum radiation along the line of sight to the redshifted northeast quadrant may result from the intersection of the ionization cone and the plane of the host galaxy. Finally, the evidence for shock-induced continuum radiation at the point where the emission-line knots begin to decelerate indicates that the deceleration is due to the interaction of emission-line knots with slower moving gas, such as the interstellar medium of NGC 1068.