During a business trip to Afghanistan to demonstrate Stark Industries' new weapon, the "Jericho" cluster missile, Tony Stark's (Robert Downey Jr.) military convoy is attacked. In the ensuing firefight, Stark is wounded by one of his own company's bombs, which knocks him unconscious and embeds shrapnel in his chest, one fragment dangerously close to his heart.
Approximately 36 hours earlier, Stark avoids his own Apogee Awards ceremony to gamble at a Las Vegas casino, leaving his deceased father's friend and business partner, Obadiah Stane (Jeff Bridges) to collect the award. As Stark leaves the casino with his entourage, he is approached by Vanity Fair reporter Christine Everhart (Leslie Bibb), whom he charms into a one-night stand at his Malibu house. As she awakens in the morning, she is escorted from the house by Pepper Potts, Stark's personal assistant (Gwyneth Paltrow), who reveals that Stark is away on a business trip. In Afghanistan, Stark's convoy is attacked, and he loses consciousness. Waking up hours later in an Afghan cave, Stark discovers an electromagnet attached to his chest, powered by a car battery and designed to keep the shrapnel from piercing his heart and killing him.
Stark has been captured by the terrorist group known as the Ten Rings, who order him to build a Jericho missile for them. Instead, during the three months of his captivity, he and fellow captive Dr. Yinsen (Shaun Toub) begin building a miniature "arc reactor", a smaller version of a power source previously invented by Tony Stark's father, Howard Stark. With the reactor powering his electromagnet, Stark and Yinsen secretly build a crude but strong power armor as a means of escape. Despite breaking free from their cell, Dr. Yinsen is killed whilst setting up a diversion for Stark in order for the suit to power up in time. In the suit, Stark kills several terrorists, destroys their weapons stockpile and flies away before crash-landing in the desert, destroying the suit in the process. After being rescued by the Air Force and returned to the United States, Stark declares at a press conference that his company will no longer manufacture weapons. Stane tells him shortly thereafter that this move is being blocked by the members of the board of directors of Stark Industries.
Returning home, Stark retreats from the public eye and instead focuses on the design of his power suit, refining its size and improving its flight and fighting capability while making an improved arc reactor for himself, which he uses to replace the old one. During his first public appearance at the Walt Disney Concert Hall since his return to the United States, he spots Potts, who is wearing the gown he bought for her as a birthday present and is struck by her beauty and briefly dances with her, causing him to realize that he has romantic feelings for his assistant. As they're about to share a kiss, Potts interrupts by asking for a martini, as a ploy to hide her insecurity because of Stark's previous promiscuity. Stark is also accosted by Everhart, who shows him pictures of Stark Industries weapons in the hands of terrorist groups, including Jericho missiles. He realizes that Stane has been "dealing under the table" by supplying both the Americans and their enemies, and that Stane has been attempting to remove Stark from power. Enraged, Stark modifies his palm thrusters to shoot laser-like blasts, dons the power suit, flies to Afghanistan and rescues Yinsen's village from the Ten Rings. During the operation, Stark inadvertently attracts the attention of the United States Air Force and his friend and company military liaison, Lieutenant Colonel James Rhodes (Terrence Howard), who dispatches two F-22 Raptors to intercept and eliminate the unknown target. During the dogfight, one of the planes is accidentally destroyed, but the pilot is rescued by Stark, who privately calls Rhodes to reveal that he was the unidentified object. Rhodes later classifies the incident as a training accident to the press, at Stark's request.
Determined to amend his mistakes, Stark sends Potts to find the shipping records of Stark Industries, so he can track the illicit shipments and destroy them. While hacking into the system, she discovers that Stane hired the Ten Rings to kill Stark and the group reneged on the deal upon discovering his true identity. She also learns Stane has recovered the power suit prototype and reverse-engineered his own version, but his engineers are unable to duplicate the miniature arc reactor to power the new suit. Stane ambushes Stark in his house, using an experimental Stark Industries device to temporarily paralyze him and removing the arc reactor from Stark's chest to power the new suit. As Stane leaves, the dying Stark manages to re-install his first reactor to save himself. Although his first reactor was not designed to power his latest armor, Stark takes it to battle with Stane atop Stark Industries and the surrounding streets, luring him atop the full-sized arc reactor at Stark Industries. With no more power left for the suit, Stark instructs Potts to overload the Arc Reactor, as Stane's suit is temporarily disabled. Potts overloads the reactor, causing an electrical surge that knocks Stane unconscious, causing him to fall into the reactor itself, destroying the reactor and himself in the process.
In the following days, the press has dubbed Stark's alter ego "Iron Man." Rhodey informs a press conference that what happened at the company's site was a malfunctioning of a robotic prototype, and one of Stark's bodyguards bravely donned a prototype exoskeleton he designed to stop it. Before joining Rhodes, Stark briefly made an attempt to establish a romantic relationship with Potts, but is put on hold. During the press conference, Stark considers telling the cover story given to him by his S.H.I.E.L.D. contact, however he inadvertently reveals hints about his new ego. Failing to secure the cover story, Stark instead abandons it and announces much to the surprise and awe of the press before him that he is Iron Man.
Following the closing credits, Stark is visited by S.H.I.E.L.D. Director Nick Fury (Samuel L. Jackson) who warns him that he is not the only 'super hero' in the world, and states he wants to talk to him about the "Avenger Initiative".