Paranormal Activity is not a small film—it’s a tiny film.

Shot by an Israeli videogame designer named Oren Peli over the course of a couple of years—with unknown actors, in his house—this scary little movie has been attracting the kind of buzz that inevitably leads people to invoke the mother of all cheapo scary movies, The Blair Witch Project. (That 1999 film had a budget of $60,000 and went on to gross a stunning $250 million worldwide.)

It’s remarkable that a major studio—Paramount—is distributing such a tiny film, though that may say as much about the state of Paramount as it does about the movie. What’s also remarkable is that Paranormal Activity has attracted the attention of a Wall Street analyst: On Monday, Rich Greenfield of Pali Research posted an item about the film under the headline, “ Scariest Movie of All Time?”

The film may not be that, but it sure is off to a great start. Last weekend, it played midnight screenings in 33 locations to sellout crowds. But like many overnight sensations, this one was a few years in the making.

“Jason, I have bad news for you. Steven watched the movie and shut it off halfway through.” This was a little film-executive humor: Spielberg had stopped watching because it was so creepy.

After he finished Paranormal Activity, Peli had managed to get the film screened for horror fans at the 2007 Screamfest Film Festival. That landed him representation at Creative Artists Agency but not much more. Then producer Jason Blum took a look at a DVD of the film that the agency had sent around town.

Formerly co-head of acquisitions at Miramax in the heyday of the Weinstein brothers, Blum had once passed—like just about everybody else—on The Blair Witch Project. And that has haunted him ever since. “What I took away from that experience is—and it sounds like a cliché—is if you see something, if you really believe in it, it doesn’t matter how many people say you’re out of your mind,” Blum says. (Hear my interview with Blum on the public radio show The Business here.)

Blum and his producing partner, Steven Schneider, told CAA they wanted to come on as producers. And Blum came up with a plan: Screen the film in front of an audience, invite a couple of reporters who might write about how great it was, and wait for offers. He invited writers from the Los Angeles Times and Variety, and both wrote admiringly of the film. Nothing happened.

The movie had another shot after it was screened at the Slamdance Film Festival in January 2008. That attracted the attention of DreamWorks executive Ashley Brucks. She got her boss, Adam Goodman, to watch the film and DreamWorks—which then distributed its films through Paramount—acquired it. The idea was to remake it in a slicker and, of course, more costly version.

Here’s where Blum pulled off a wily move: He argued that the writers of this prospective remake should see the original with a recruited audience to get a better feel for the material. Blum says he was convinced if he could get a decision-maker to see the film with an audience, the original version would get released. The March 2008 screening went so well, he says, that in the middle, “I looked over at Oren and we kind of smiled at each other.”

After that, Steven Spielberg saw the movie (on a DVD). Goodman called Blum and said, “Jason, I have bad news for you. Steven watched the movie and shut it off halfway through.” But this was a little film-executive humor: Spielberg had stopped watching because the movie was so creepy. He finished it the next day and sure enough, DreamWorks decided to release the original.

Then things went silent. Blum didn’t know why but eventually figured out that his project had been caught up in the bitter DreamWorks divorce from Paramount. When it was all over, DreamWorks had departed and the picture belonged to Paramount. Fortunately for Blum and his associates, Goodman at that point also belonged to Paramount. He was installed as head of production there, and Paranormal Activity still had a supporter at the studio.

Nonetheless, things remained quiet until August, when Paramount announced that it was pushing the release of the upcoming Martin Scorsese thriller Shutter Island from this October into 2010. It was widely assumed that Paramount acted to save costs. But the studio was left with only a couple of movies in its pipeline for the rest of this year: Up in the Air, a promising Jason Reitman-directed film about corporate downsizing with George Clooney; and The Lovely Bones, the Peter Jackson film based on the Alice Sebold novel about the rape and murder of a young girl.

It’s ironic that for want of something else to do, Paramount may have been pressed into coming up with an inexpensive and novel marketing plan for Paranormal Activity. Last month the studio held midnight screenings of the film in seven cities, hoping to build word of mouth. The studio then used eventful.com—a Web site previously used for music fans requesting concerts in their cities—so that those who had heard about the film and wanted to see it could make their wishes known.

This weekend, Paranormal Activity will expand to more than 40 markets with normal screening times. Obviously it’s too soon to say how the film will play; until now it’s only had midnight screenings in a limited number of theaters. But with foreign sales that were completed before Paramount acquired the movie, the film is already in profit. And Peli has his next film, Area 51, all lined up with a comparatively deluxe $5 million budget. Blum will produce.

And that’s what you call a Hollywood ending.

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Kim Masters covers the entertainment business for The Daily Beast. She is also the host of The Business, public radio's weekly program about the business of show business. She is also the author of The Keys to the Kingdom: The Rise of Michael Eisner and the Fall of Everybody Else.