Kurenai stumbles across an obscure meditation technique: the old rhetorical trick of using a "memory palace" to improve your memory, enhanced with chakra to become a full-fledged genjutsu cast on the self. It used to be used by infiltrators who couldn't risk committing their findings to writing, but gradually fell out of favor with the rise of sealing-scrolls' popularity. She thinks it might help her students in developing a rudimentary defense against genjutsu and in organizing their thoughts in general. Kiba doesn't like the idea too much, but Shino finds the compartmentalization interesting and useful.
Hinata, however, takes to it like a fish to water—indeed, she's too good at it. It doesn't take her long to realize that, whenever she's out of the Hyuuga compound, she can temporarily lock away her memories of her father's brutal training and scornful disdain, and feel like a free person for once in her life. The rest of her team is quick to note the meteoric rise in her confidence.
However, while she feels more free outside the Hyuuga compound, she's even more of a slave inside it. She keeps the door locked more and more, with a smaller, weaker portion of herself locked within, forced to take the punishing training from Neji, Hanabi, and Hiashi with nothing to rely on but the Gentle-Fist-and-Byakugan room that serves as the only link between her memory palace's Hyuuga section and everything else—that is to say, without the memory of Naruto. Without her experiences with the Hyuuga weighing her down, Hinata is strengthened outside the compound; without her love for Naruto buoying her up, Hinata is weakened inside the compound. The two personalities split entirely apart, with only the Juuken-and-Byakugan room shared in common.
Team Eight does very well in the first phase of the Chuunin Exams, with Hinata confidently leading the way, to Kiba's consternation and Shino's quiet surprise. In the preliminary fights, though, it all falls apart. Outside-Hinata can ignore Neji's speech and take up the Gentle Fist stance—but, being so close by, Inside-Hinata hears it as well, and is driven to a sobbing panic, imploring Outside-Hinata to back down before she's beaten into a pulp once again. The mental turmoil disrupts the concentration that Outside-Hinata is using to control her body, and Neji—against whom Outside-Hinata was about to gain an honorably-close defeat—presses his advantage. Outside-Hinata's confidence is shaken, and Inside-Hinata seizes the opportunity to take control, curl up into a sobbing, quivering ball on the floor, and surrender dishonorably. Everyone is astonished at this sudden turnabout—except Neji, who hadn't been expecting a fight at all, and is surprised that Hinata lasted even this long. He doesn't spend much time thinking about it, though.
Kurenai decides to try her limited, bastardized version of the Yamanaka's mind-walking, and is distraught beyond words to find that Hinata has succumbed to the same split-personality fate that befell her old student, Kurama Yakumo (from filler). Stricken to the marrow, she confesses her failing to Hiashi (who shows only disgust at his child's weakness) and to Hiruzen (who also is saddened greatly), and explains the situation to Kiba and Shino (who are suitably horrified). Hiashi has Hinata sealed. This is the final blow for the confidence of Outside-Hinata, who retreats into dormancy, while Inside-Hinata, who's never known anything but Gentle Fist, Byakugan, and the Hyuuga, is unprepared to be left in control. Kurenai retires from active duty to care for Hinata and Yakumo together, in an attempt to atone for her sins.