During a trip to Afghanistan to demonstrate his company's new weapon system,Tony Stark is attacked and kidnapped by a terrorist group called the Ten Rings. 36 hours earlier, at an award ceremony, US Air Force officer James Rhodes prepares to give the award to Tony, but Stark is absent. Stark's business partner takes the award for him while Tony is playing at a casino extravagantly. After Rhodes shows his disappointment to Tony that he didn't show up, Stark prepares to leave when he is suddenly approached by a reporter, Christine Everhart. Stark and Everhart end up having a one-night stand. Afterwards, Tony's assistant prompts Everhart to leave. Several hours later, Tony demonstrates his revolutionary multi-warhead cluster bomb missile, Jericho, to the US Air Force.
Shortly thereafter, the kidnapping occurs and the terrorists reveal that they want Stark to build them a version of his weapon system, the 'Jericho'. Instead, over the next three months with the aid of a fellow captive, Dr. Yinsen, he builds a crude but very strong power armor, powered from a miniature arc reactor Stark and Yinsen built to power an electromagnet "pacemaker", which protects Stark's heart from the embedded shrapnel in his chest. Dr. Yinsen is killed trying to make sure Stark has enough time to prepare escaping, in the ensuing escape attempt, but Stark gets away and is picked up by the Air Force soon after in the desert. Upon returning to the United States, Stark declares that Stark Industries will no longer manufacture weapons, a move which his business partner and second-in-command CEO Obadiah Stane tells him is blocked by the board members shortly after.
During his self-imposed sabbatical from public life, Stark tinkers with the design of his power suit (albeit to several injuries he endures), refining it to be capable of flight, and builds a more powerful and reliable arc reactor, both to power his pacemaker and the suit. Meanwhile, Raza, the leader of the Ten Rings terrorist group, has dispatched his men to recover the Mark 01 Armor, which they find in the desert after Stark abandoned it (from falling from his airborne escape in a comical manner). After finding the armor, Raza orders his men to rebuild it again. During Stark's first public appearance since his kidnapping, he is shown, by Everhart, pictures of Stark Industries weapons in the hands of terrorist groups (particularly the Ten Rings), including the system he refused to build for them. He also discovers that Stane has been "dealing under the table" to both sides in the conflict, as well as being the one to shut Stark out of the board while he recovers. Faced with the realization of what his company has done, Stark dons the power suit and flies to Yinsen's village of Gulmira in Afghanistan; rescuing the villagers from terrorists by employing his repulsors and his shoulder-mounted automatic tranquelizer guns. Iron Man also grabs one of the terrorists' leaders and leaves him at the mercy and discretion of the vengeful villagers. Raza sees Iron Man flee to the weapon stockpiles.
After a brief battle with an enemy tank, Iron Man destroys their weapon stockpiles, but accidentally draws the attention of the United States Air Force and his friend, Jim Rhodes. After a supersonic dogfight between Stark and two F-22s, one jet gets damaged in Stark's attempt to hide, making the pilot eject. The pilot's eject seat malfunctions but Stark manages to save the pilot's life. After this ordeal, Stark reveals to Rhodes that he's Iron Man and Rhodes covers it up by stating that it was "a training exercise".
After viewing the news of the Gulmira F-22 incident, Stane goes on a business trip to the Ten Rings encampment in Afghanistan where it becomes apparent that Stane paid and ordered the Ten Rings to kill Stark. Raza reports to Stane that Stark has perfected his armor design into the Mark 03 Armor and because Stane and Raza have a common enemy, Stark, Raza plans to broker a deal: the Mark 01 Armor designs for Stane and in exchange "the gift of iron soldiers" to Raza and his terrorist followers. Stane ultimately betrays Raza by incapacitating him with an amplified sound paralyzer and orders his guards to kill all of Raza's men. After leaving, Stane, over the phone, secretly sets up Sector 16 at Stark Industries to use the armor designs. Determined to make amends for his mistakes, Stark sends his assistant Virginia Potts to find the shipping records of Stark Industries, so he can track down the illicit shipments and destroy them. While hacking into the system she discovers that it was Stane who hired the Ten Rings to kill Stark, but they had reneged on the deal when they realized who the target was. She also discovers that Stane has recovered the power suit prototype, and has reverse engineered his own version.
Realizing that Pepper is aware of his evil deeds, Stane steals Stark's arc reactor to power his suit after also learning that his scientists in Sector 16 can't copy Tony's ingenious invention of making the company's large arc reactor smaller. Stane reveals his involvement in the kidnapping to Tony after he paralyzes him with the sound amplifier so that he can steal his arc reactor without resistance. After briefly expounding upon his agenda of world domination and the ideals of power in the corporate business, (particularly stating that Howard Stark, Tony's father, helped the atomic bomb become a reality), Stane leaves Stark for dead. Pepper tells Rhodes about Obadiah's wrongdoings and therefore, he goes to Tony's house where Stark struggles to receive his first arc reactor to sustain his life. Stark's incompetent robotic arm system in his garage redeems itself by generously giving Stark his needed arc reactor after he collapsed. Rhodes sees Stark putting on the Mark 03 Armor, admiring its design. He asks if there's anything he can do to help Stark, and Tony asks him to keep the skies clear. After Stark leaves, Rhodes sees another armor prototype and says, "Next time, baby!"(a nod to War Machine). Meanwhile, Pepper and several SHIELD agents attempt to arrest Obadiah at Stark Industries headquarters but Stane puts on his armor, thus becoming Iron Monger. Just before Iron Monger is about to kill Pepper, Stark as Iron Man interferes and battles him on the streets. Their epic battle takes them to the skies where Iron Man seemingly defeats Iron Monger because Stane's armor can't withstand ice beyond the atmosphere. Afterwards, atop the Stark Industries building, Iron Monger surprisingly bests Iron Man but in a last valiant move, Stark orders Pepper to overload the large arc reactor which powers the building. The resulting blast kills Stane and incapacitates Tony. Because Stark's reactor is nearly drained, he is protected from the EMP and survives.
The film ends with a press conference about the battle. Although advised by SHIELD Agent Cole to claim Iron Man is his personal body guard and corporate mascot, Tony instead announces that he is Iron Man. After the closing credits, Stark is greeted by General Nick Fury , director of SHIELD, who tells him about the Avenger Initiative.