The movie begins with Tony Stark (Robert Downey Jr.) riding with soldiers on duty in Afghanistan. He is joking with some members of a convoy who seem to be genuinely amused by his persona and his flamboyant public image. Suddenly, the convoy is attacked. The soldiers fight to defend themselves but are quickly killed. Stark flees the Humvee, taking refuge behind a large rock. A missile lands nearby, remaining intact long enough for Tony to see the Stark Industries logo on it. It explodes sending shrapnel into Tony's chest despite the body armor he wears. Tony is captured and recorded on video by a group of masked terrorists.
A flashback sequence reveals Tony's history as a child prodigy before taking over his father's company, Stark Industries, at age 21. Colonel James "Rhodey" Rhodes (Terrence Howard) attends a ceremony to present Tony Stark with an award for his work, but Tony is not in attendance. Tony's right-hand man (and his father's former partner) Obadiah Stane (Jeff Bridges) accepts the award in Tony's stead. Rhody later finds Tony partying in a casino. On his way out, a reporter named Christine (Leslie Bibb) approaches Stark with some questions regarding the ethics of his weapons business. Stark deflects her questions with some swift quips and the two end up spending the night together at Tony's oceanfront house.
The next morning, Christine is awakened by a voice on a computer monitor. It's JARVIS, the artificially intelligent program responsible for running Tony's house and his research lab. Christine is greeted by Tony's assistant, "Pepper" Potts (Gwyneth Paltrow) as she leaves the house. Pepper helps Tony catch up on some business before Tony heads out to the airport where his plane awaits. In flight, Tony talks with Rhodey. Rhodey is unhappy about Tony's lax attitude, and Tony tries to get his old friend to relax. Before long they are drunk and leering at the stewardesses.
Tony arrives at a military outpost in the Afghanistan to demonstrate his company's latest project - the Jericho, a super-missile system. After the demonstration, Tony gets a phone call from Obadiah and they are both pleased that the demonstration went well. Tony goes off with the convoy that is soon attacked by terrorists.
Much later, Tony regains consciousness in a cave. His chest is hooked up to a strange device. Another captive, named Yinsen (Shaun Tomb), explains that he operated on Stark but was unable to remove all the fragments from the bomb blast. Yinsen created a device - essentially electromagnet powered by a car battery - that will keep the remaining fragments from shifting and causing further damage to his heart. The terrorists who captured Tony & Yinsen enter the room. Yinsen translates; they want Tony to build them a Jericho missile. Tony refuses and they torture him, shoving his face in a tub of water.
Hours later, the terrorists, a group called the The Ten Rings, show off a huge stockpile of weapons - all made by Stark Industries. Tony appears to relent and start building the missile, but has other plans. With Yinsen's help, and using palladium collected from his weapons, Tony constructs a tiny version of an arc reactor, streamlined from a much bigger design used at his company's headquarters. The power output is enough to run Stark's heart for "fifty lifetimes... or something much bigger for about 15 minutes." It will also be enough to keep the shrapnel in Tony's heart from shifting any further and killing him.
Tony designs a way out for himself and Yinsen - an armored suit powered by the arc reactor that he will wear and use to defeat the terrorists. Midway through construction, the head of the Ten Rings, a man named Raza (Faran Tahir) arrives and threatens to torture Yinsen, angry because he thinks Stark is not working on the Jericho as they wanted. Tony bargains for Yinsen's life, saying he makes a good assistant. Raza gives them one more day to finish.
Working furiously overnight, Tony completes his project. Yinsen straps Tony into the completed armored suit, telling him the way out of the cave. They set off a bomb inside the cell door as a distraction for the guards as Tony powers up his suit. Yinsen realizes that they will not have enough time. He grabs a gun and runs off to distract the surviving guards.
Tony, fully powered, muscles his way through the cave. The guards try to stop but his suit easily deflects their weapon fire and he beats them off or kills them. He also fires one of the suit's missiles at Raza himself, who is flung out of sight by the blast. Halfway out of the cavern, Stark finds Yinsen, mortally wounded. Yinsen reveals that this was his plan, sacrificing himself so Tony could escape - Yinsen's family is already dead and he will now see them again in the afterlife. Tony tearfully thanks Yinsen for saving him. Yinsen's last words to Stark are not to waste his second chance at life.
Tony turns his suit on the remaining terrorists, igniting flame-throwers and firing missiles. He destroys their stockpile of weapons, however, some of their larger caliber weaponry begins to damage his suit. He uses a rudimentary jet-pack to blast from the valley. Not long after firing, his jet-pack fails and he crashes in the desert, but survives. Stark hikes through the desert until a couple of US helicopters fly overhead. A group of soldiers, led by Rhody, come across Tony. Rhody is overjoyed to find that his friend is alive.
Tony returns to the United States after three months in captivity. Pepper wants Tony to receive medical treatment, but Tony states that there are only two things he wants: an American cheeseburger and a company press conference. Shortly after, Tony appears before a group of reporters and, clearly humbled and no longer the arrogant CEO he was before his capture, announces that he intends to shut down Stark Industries' weapons manufacturing division immediately. At the same time, Pepper is approached by Agent Phil Coulson (Clark Gregg) of the Strategic Homeland Intervention Enforcement & Logistic Division agency. They want to talk to Tony Stark about his capture. Pepper schedules an appointment for them.
That evening, Obadiah confronts Tony about his actions, furious. Obadiah knows that the stock value for their company (and, by extension, their financial status) is going to take a serious drop because of this announcement. Tony wants Stark Industries to move forward with arc reactor technology, but Obadiah thinks that the arc reactor is nothing but a publicity stunt. Through the conversation, Tony ends up revealing his prosthetic power-heart to Obadiah but refuses to allow the device to be studied for production. Stane convinces Tony to lay low for a while so the company can sort things out.
Pepper watches a news report on the declining value of Stark Industries when Tony asks for her help. He's created an upgraded mini arc reactor, the "Mark II chestpiece", but can't install it into his chest without someone to help. Pepper accidentally yanks out the cords for the old reactor too soon, putting Tony on the verge of cardiac arrest. They manage to complete the process in time. Tony tells Pepper to destroy the old model since he's not a sentimental person.
Tony visits Rhodes and asks for help with a new private project. Rhody does not agree with Tony's approach; he thinks Stark is suffering from post-traumatic stress disorder because of his capture and needs time to recover.
Tony turns to his other best friend - JARVIS - for help. Tony's plan is revealed to be an upgrade to his armored suit (referred to as "Mark II," with the suit from the terrorist cave being "Mark I"). Tony, studying a 3D CGI-mapped image of the Mark I, discards many of the components, streamlining the design.
Meanwhile, Raza, having survived his battle with Stark and the Mark I, searches the desert, gathering all fragments of the Mark I suit.
Tony decides that the first thing he has to do is to perfect the armor's flight system. Since the leg-mounted jets proved too unstable, he creates repulsors for the feet and arm-mounted stabilizers to balance out the system. Pepper comes in when he is testing the stabilizers and they find that it also creates a powerful repulsion beam that could also be used as a weapon. Pepper leaves a paper-wrapped box on Tony's desk as a gift.
Obadiah visits Tony and reveals that the board of directors have filed an injunction to gain control of Stark Industries. Tony isn't worried; he still maintains controlling interest in Stark Industries.
After several failed and obviously painful attempts, Tony finally manages to perfect his flight system, and is delighted at the prospect of flying.
A new armored suit is soon finished, the Mark II, looking like a heavily-streamlined version of Tony's Mark I armor. Tony connects with Jarvis to monitor the progress in the suit. Against JARVIS' advice, Tony decides to take it out for a test flight, and he is thrilled by the suit's functionality. Tony decides to push the limit for higher-atmosphere flying, but at such great heights the suit becomes coated with ice and his power supply shuts down. Tony is barely able to reactivate his thrusters in time to avoid crashing into the ground. Stark returns home, but the armor is so heavy that it crashes through three floors of the house. As Tony recovers from his crash landing, he opens the box that Pepper left behind earlier - inside is the Mark I arc reactor, encased as a trophy with the message, "Proof That Tony Stark Has A Heart."
Tony analyzes more data and decides to rebuild the suit using gold titanium from an old project to solve the icing problem. Tony also instructs Jarvis to add some "hot-rod red" paint trimming to the next suit, codenamed "Mark III." Tony then leaves to attend his annual benefit dinner while the new suit is being assembled and painted.
At the charity event, Tony meets with Agent Coulson, who still wants to learn about Tony's incident. Tony then leaves to dance with Pepper and they share a moment together in the moonlight.
Tony is then confronted by Christine, the reporter he'd slept with prior to leaving for Afghanistan. She shows him photographs of his weapons being used by a terrorist group the previous day in the remote Afghan town of Gulmira, Yinsen's home village. Tony confronts Obadiah on the matter, and Obadiah reveals that he is the one who filed the injunction against Tony. Obadiah calls himself an "iron monger," and has no qualms about selling Stark Industries weapons to both sides of the conflict. Tony returns home, furious. While there he watches news reports of the worsening situation in the Gulmira region. He tests modifications to his hand repulsors, turning them into a weapon. When the new suit is completed it is fashioned to his body by an automated robotic system. Stark flies off to Gulmira at hypersonic speed, determined to right his company's wrongs.
In Gulmira, terrorists are rounding up civilians for capture & execution when they are confronted by Stark, whose Mark III armor is more than a match for them. Within seconds, he defeats the first group of terrorists, using his advanced weapons to take out several without any innocent casualties. He destroys the terrorists' missiles. He leaves the group's leader, Raza's chief lieutenant, alive and defenseless for the villagers to take their revenge on.
While flying to find his weapons, Iron Man is shot down by a tank shell. Getting up, a second shell barely misses him. He responds by shooting a mini-missile at the tank, destroying it. Using the palm repulsors he designed, he destroys the captured Jericho missiles. After they are demolished, Raza arrives in time to see Tony fly off.
During the fight, CENTCOM detects Stark in flight. Col. Rhodes is asked about the status of any new developments. He contacts Tony, who claims that he knows nothing about what is happening. In the meantime, Iron Man is confronted by two F-22's. He tries to outrun the jets but they are too much for him. Tony calls Rhodes and reveals that he is responsible for the "unidentified craft." Rhody is furious about Tony sending in unauthorized equipment, and horrified when Tony explains that the "equipment" is actually himself in his new invention. Iron Man is hit by one fighter jet, sending him flying into the wing of the second jet. The pilot is forced to eject, but the parachute fails to open. Iron Man, still under fire, manages to fly in and successfully deploy the parachute in time to rescue the pilot. Tony convinces Rhody to pass off what happened with the jets as a "training exercise."
After Tony arrives back at home, Pepper catches him removing the battle-damaged Iron Man armor. The removal is not going as well as the assembly.
Meanwhile, the Ten Rings terrorist group is visited by none other than Obadiah. It is revealed that Stane paid the Ten Rings members to capture and kill Stark, but they realized who Stark was and demanded a much higher price. Using a high-powered sonic device that induces temporary paralysis, Stane immobilizes Raza and takes the remnants of the Mark I armor they have gathered. Stane then has his men execute everyone in the camp.
Tony tries to talk Pepper into helping him, believing that nothing else matters but stopping the people who he put in harm's way. Pepper is moved by Tony's dedication, and agrees. She goes into Obadiah's office with flash drive programmed to copy files from the computer. As Pepper sifts through stored files, she finds a video from the terrorists proving that Obadiah was responsible for Tony's capture. Obadiah comes into the office and sees her at the computer, but Pepper manages to hide what she is really doing. She leaves the office, however, as soon as he powers up the computer, Obadiah realizes what she was up to. On the way out, Pepper sees Agent Coulson and tells him he can have his interview immediately so that he accompanies safely out of the building.
Obadiah meets with his team of developers who are working on his own armored suit based on the Mark I. They have rebuilt the components, but they cannot miniaturize Stark's arc reactor. Stane is furious, then realizes that he has one other option.
Stane arrives at Tony's house and paralyzes him with the sonic weapon. Obadiah yanks out the the Mark II chestpiece from Tony's chest, taunting him about how it will be the flagship invention in a new era of weaponry. After he leaves, Tony realizes that he has only one hope for survival - the preserved arc reactor that Pepper gave him in a display case. He gets the power source installed just as Rhody arrives. Rhody informs him that 5 agents have gone to arrest Obadiah but Tony knows that is not enough manpower.
Rhody watches Tony suit up, awestruck at the Iron Man armor. Rhody asks if there's anything Tony needs, Tony asks him to "keep the skies clear". As Tony flies away, Rhody spots the silver-colored prototype suit, the Mark II... then shakes his head and mumbles "Next time."
Pepper, Coulson and several other agents arrive at Obadiah's research facility. They spot the Mark I Armor and a storage location where something else was kept. Just then, a gigantic robotic suit comes to life and attacks them - it's Obadiah's counterpart suit, code-named the Iron Monger, powered by the chest piece he'd stolen from Tony.
While flying towards the research facility, Jarvis warns Tony that he has only about half power in the suit because the older chestpiece wasn't designed power the Mark III's flight capability.
Iron Man arrives just as the Iron Monger is about to execute Pepper and begins to fight him. The two ironclad warriors have a huge battle that spills into the streets near Stark Industries. Tony flies into the upper atmosphere, drawing Stane along with him. Iron Monger struggles but before long begins to freeze up - his suit has the same icing problem that Tony's Mark II had. Iron Monger begins to fall back to Earth, leaving Tony hovering above. The older arc reactor begins to lose power rapidly and Tony falls back to Earth, landing on top of his factory, running on auxiliary backup power.
Back on the ground, the Iron Monger attacks Tony again. He manages to evade Stane long enough to instruct Pepper to overload the building's arc reactor, which will generate a shockwave strong enough to disable the Iron Monger's suit. Pepper is hesitant, believing that Tony could also be killed. Tony manages to keep fighting while she builds up power to the reactor. The reactor releases its shockwave, knocking out the Iron Monger, which falls into the reactor, killing Stane and destroying the reactor. Stark's original mini arc reactor sparks back to life, allowing Tony to survive.
Days later, Rhody holds a press conference about the incident with the two "robots." Tony is impressed with the newspapers coming up with the name "Iron Man," and plans to adopt it. Agent Coulson has released cover stories about Obadiah (who will die in a small plane crash) and the "truth" about Iron Man (who will be referred to as Stark's bodyguard). Pepper thanks Coulson but cannot remember the full name of the group he belongs to. Coulson just tells them to call it "S.H.I.E.L.D." and states that they will be in touch again.
Tony goes before the reporters once more, and prepares to comply with the cover story. But, as he begins talking, he throws away his notes and declares "I am Iron Man." The press goes into a frenzy.
Much later (after the credits), Tony returns home to find a mysterious man in black telling him that as Iron Man, Tony has become part of a larger universe. Tony asks who the man is. He turns around and introduces himself- Nick Fury, Director of S.H.I.E.L.D. (Samuel L. Jackson). He's come to talk with Tony Stark about an upcoming project known only as "The Avenger Initiative."