Tony Stark, who has inherited the defense contractor Stark Industries from his late father Howard Stark, is in war-torn Afghanistan with his friend and military liaison, Lieutenant colonel James Rhodes, to demonstrate the new "Jericho" missile. After the demonstration, the convoy is ambushed and Stark is critically wounded by a missile used by the attackers: one of his company's own. He is captured and imprisoned in a cave by a terrorist group called the Ten Rings. Yinsen, a fellow captive doctor, implants an electromagnet into Stark's chest to keep the shrapnel shards that wounded him from reaching his heart and killing him. Ten Rings leader Raza offers Stark freedom in exchange for building a Jericho missile for the group, but he and Yinsen know that Raza will not keep his word.
Stark and Yinsen secretly build a small, powerful electric generator called an arc reactor to power Stark's electromagnet and a prototype suit of powered armor to aid in their escape. Although they keep the suit hidden almost to completion, the Ten Rings discover their hostages' intentions and attack the workshop. Yinsen sacrifices himself to divert them while the suit powers up. The armored Stark battles his way out of the cave to find the dying Yinsen, then burns the Ten Rings' weapons and flies away, crashing in the desert and destroying the suit. After being rescued by Rhodes, Stark returns home and announces that his company will cease manufacturing weapons. Obadiah Stane, his father's old partner and the company's manager, advises Stark that this may ruin Stark Industries and his father's legacy. In his home workshop, Stark builds a sleeker, more powerful version of his improvised armor suit as well as a more powerful arc reactor for it and his chest. Personal assistant Pepper Potts places the original reactor inside a small glass showcase. Though Stane requests details, a suspicious Stark decides to keep his work to himself.
Stane's scientists cannot duplicate Stark's miniaturized arc reactor, so Stane ambushes Stark at his home and steals the one from his chest. Stark manages to get to his original reactor to replace it. Potts and several S.H.I.E.L.D. agents attempt to arrest Stane, but he dons his suit and attacks them. Stark fights Stane but is outmatched without his new reactor to run his suit at full capacity. The fight carries Stark and Stane to the top of the Stark Industries building, and Stark instructs Potts to overload the large arc reactor powering the building. This unleashes a massive electrical surge that causes Stane and his armor to fall into the exploding reactor, killing him. The next day, at a press conference, Stark publicly admits to being the superhero the press has dubbed "Iron Man".
In a post-credits scene, S.H.I.E.L.D. Director Nick Fury visits Stark at home, telling him that Iron Man is not "the only superhero in the world", and explaining that he wants to discuss the "Avenger Initiative".
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