Well the Mortal Kombat II storyline is:

Following his defeat (in the first Mortal Kombat game), Shang Tsung begs his master, Shao Kahn, to spare his life. He tells Shao Kahn that the invitation for Mortal Kombat cannot be turned down, and if they hold it in Outworld, the Earthrealm warriors must attend. Kahn agrees to this plan, and restores Tsung's youth. He extends the invitation to Raiden, who gathers his warriors and takes them into Outworld. The tournament is dangerous, as Shao Kahn has the "home field advantage", and an Outworld victory will unbalance the furies and allow Outworld to subsume Earthrealm.

And the Mortal Kombat 3 storyline is:

Fed up with continuous losses in tournament battle, Shao Kahn, who had lost to Liu Kang in the Outworld tournament, enacts a 10,000 year-old plan. He would have his Shadow Priests, led by Shang Tsung, revive his former Queen Sindel, who unexpectedly died at a young age. However, she wouldn't be revived in the Outworld. She would be resurrected in the Earthrealm. This would allow Shao Kahn to cross the boundary lines and reclaim his queen.

When Sindel is reincarnated in Earthrealm, Shao Kahn reaches across the dimensions to reclaim her. As a consequence of his action, the Earthrealm becomes a part of the Outworld, killing billions instantly. Only a few are spared, as Raiden protects their souls. He tells them that Shao Kahn must be stopped, but he cannot interfere; due to his status, he has no power in Outworld, and Earthrealm is partially merged with Outworld.

Shao Kahn has unleashed extermination squads to roam throughout the Earthrealm and kill any survivors. Also, Raiden's protection only extends to the soul, not to the body, so his chosen warriors have to fight the extermination squads and repel Shao Kahn. Eventually somehow every human on Earthrealm comes back.

As you can see, these stories are completely different, and happen directly after each other, so no, the MK2 storyline was not scrapped for Mortal Kombat 3. They are both canon (confirmed true parts of the storyline).

The contradictions of MK:II and MK: Shaolin Monks are:

1. The official Mortal Kombat II comic book was believed to be canon since it was written by John Tobias, the co-creator of the Mortal Kombat series who left Midway before this game was developed. The comic is contradicted by the story presented in Shaolin Monks. While the fundamental basics remain the same (Shang Tsung's island crumbles, the Shaolin temples are destroyed, Shang Tsung regains his youth, the Earthrealm warriors are lured into Outworld etc.), the details and order of many events and whom fought whom are largely different.

2. Sub-Zero's scar has never officially been explained in the Mortal Kombat storyline until Shaolin Monks. Shaolin Monks invalidated the long held fan theory that he was scarred by the Lin Kuei when he left the clan in Mortal Kombat 3 by having him scarred in a fight with Kung Lao. His bio in Mortal Kombat Trilogy states that he was marked for death by the Lin Kuei. Shaun Himmerick, the producer of Shaolin Monks, has stated in an online chat "Fight Night" held at the fan site Mortal Kombat Online that the term "marked for death" was meant figuratively. [2]

3. Kung Lao was not present in the first Mortal Kombat game. In Shaolin Monks, he is shown to have snuck onto Shang Tsung's island during this tournament, posing as one of his guards and participating in the final battle along with a few Tarkata warriors.

4. Liu Kang was present when the Tarkata attacked the Shaolin Temple, and helped to fight them off. His Mortal Kombat II bio made clear he was not present at the battle.

5. Liu Kang was portrayed as being naive and Kung Lao as being arrogant and jealous of Liu Kang's victory in the tournament. Neither of these attributes were shown in character storylines of previous games. They were also portrayed as somewhat immature at times (for example, Kung Lao constantly referring to Kitana as Liu Kang's "girlfriend" and Liu sharply responding to Kung Lao with "she's not my girlfriend!").

6. The elder Sub-Zero was killed by Scorpion in the first Mortal Kombat game. In Shaolin Monks, he survived the tournament, and was eventually killed by Scorpion sometime later.

7. Goro was defeated by Liu Kang in the first Mortal Kombat game, and he was lost in the aftermath. His Outworld allies believed that he had been killed by Kang, only for him to return in Mortal Kombat 4. In Shaolin Monks, Goro survived the original Mortal Kombat tournament, and returned with Shang Tsung to Outworld. He was later "killed" there by Johnny Cage. Besides Goro, a few others of the MK character roster were "killed" in Shaolin Monks (Jade, Baraka, Reptile, Kano, Shang Tsung and Kintaro), all of which have appeared in games set after this one (made before and afterwards). Their deaths and subsequent resurrections are left unexplained in subsequent games. John Edwards of Midway has stated the boss fatalites were included as they "seemed much more entertaining than having the bosses run away when you beat them". He also noted that the "other option was to have them all run away after you defeated them. Seemed less fun." [2]

8. Shang Tsung is seen restoring his own youth with a combination of fresh souls and powerful magic. However, his MKII bio and the comic state that it was Shao Kahn who restored his youth and strength.

9. Reptile says that he doesn't serve Shang Tsung, when the player meets him for the first time. His MKII bio states that he had served as Tsung's bodyguard in the first game.

10. The younger Sub-Zero and Noob Saibot meet in Shaolin Monks, and Sub-Zero is somewhat aware of Noob’s true identity. Noob-Smoke’s ending in Mortal Kombat: Deception mentioned that Noob hadn’t seen his brother since before he died, but it wasn’t known if Sub-Zero had seen him or knew of his true identity. Obviously, he did know Noob's true identity.

11. Kitana is shown having had full knowledge of what Shao Kahn did to her family (thus, she had fought against his rule during that time), and is put under a holding spell to gain her loyalty and erase her memories of her original parents and what Kahn had done to them. In her Mortal Kombat II ending, it tells that Kitana had learned of her true past during her years as an assassin, and only feigns loyalty to the Emperor, with no spell mentioned. This idea is not contradicted anywhere else in the MK series, however.

12. Jax, a member of the U.S. Special Forces, had the ability to open portals in Shaolin Monks. This technology didn't exist until the Outer World Investigation Agency was created after Mortal Kombat 3, when Shao Kahn had invaded Earthrealm. Until that point, only sorcerers (like Shang Tsung) and deities (like Raiden) could open portals.

13. Quan Chi is seen bearing tattoos. However, this contradicts the story leading up to Mortal Kombat: Deadly Alliance. During this time, he discovered markings that revealed secrets about his amulet, then burned those same markings onto his skin.

14. Scorpion was shown to suddenly attack Liu Kang and Kung Lao. This gave the impression that Scorpion had an evil alignment, even though Scorpion has been a neutral character throughout the course of the MK timeline.

15. Reptile’s lizard-like features are more evident here than in MKII. Originally, Reptile had covered his true appearance with a human-like skin suit and mask, before abandoning the suit in MK4, and his de-evolution sometime before Deadly Alliance. However, if both players were to play as Reptile in versus mode, the second player would look more like what Reptile had looked like before his de-evolution.

16. At the end of the game, it was revealed that Shao Kahn was in possession of Quan Chi’s amulet, and Quan Chi himself is seen retrieving it. This spurred a controversy among fans of the series, because it was believed that Quan Chi had the amulet since the end of Mortal Kombat Mythologies: Sub-Zero (set before the first Mortal Kombat), and it isn’t known how Kahn came to have it.

17. The location of the "Warrior Shrine" arena was assumed to be on Shang Tsung's island, but now it's located near the Shaolin Temples.

So I hope this answers all your questions about your understanding of the Mortal Kombat Storyline. If not, PM me, and I will post more in this thread to answer any further questions you may have.

Read this. Long, but should answer most questions you have.
On the second page, I start discussing the games' stories from MK1-Deception. And the last page has a post on Shaolin Monks.