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During a business trip to Afghanistan to demonstrate Stark Industries' new weapon, the "Jericho" cluster missile, Tony Stark's convoy is attacked. One of his own company's bombs lands near him and explodes. The blast causes him to lose consciousness and embeds several pieces of shrapnel in his chest, one fragment dangerously close to his heart. He wakes up some time later with an electromagnet attached to his chest. Hooked up to a car battery, the electromagnet keeps the shrapnel from entering his heart and killing him.

Stark has been captured by the terrorist group Ten Rings, who order him to build a Jericho missile for them. Instead, he and fellow captive Dr. Yinsen secretly build a crude but strong power armor fueled by a miniature "arc reactor", a smaller version of a power source previously invented by Stark. The arc reactor supplies energy to an electromagnet which prevents embedded shrapnel from reaching Stark's heart, which would kill him. Dr. Yinsen is killed in the ensuing escape attempt when he stalls the guards to buy Stark enough time to power up the suit. Using the suit, Stark kills several terrorists, destroys their weapons stockpile, and escapes, though his suit is destroyed as he crash lands in the desert. Upon being picked up by the Air Force and returning to the United States, Stark declares that his company will no longer manufacture weapons. His father's friend and business partner, Obadiah Stane, tells him that this move is blocked by the board members shortly after.

Stark retreats from public view, focusing on the design of his power suit, refining its size and flight capability. He also builds a more powerful and reliable mini-arc reactor to power both his life support and the suit. During his first public appearance since his return to the United States, he is accosted by a reporter who shows him pictures of Stark Industries weapons in the hands of terrorist groups, including the Jericho missiles he refused to build for them. He also discovers that Stane has been "dealing under the table", supplying weapons to both the U.S. troops and the terrorists, 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 Afghanistan, rescuing Yinsen's village from the Ten Rings. In destroying their weapon stockpiles, he accidentally draws the attention of the United States Air Force and his friend and company military liaison, Lieutenant Colonel James Rhodes. Two F-22 Raptors are ordered to take out the unknown target and during the confrontation one of the Raptors loses its left wing when it collides with Stark. The pilot ejects shortly afterward but his parachute jams. Realizing this, Stark dives down to help the pilot release his parachute, before escaping.

Determined to make amends for his mistakes, Stark sends his assistant Pepper 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. However, his team of scientists, not possessing Stark's genius, cannot engineer the miniature arc reactor to power the new suit. Stane, upon realizing Pepper's discovery, steals Stark's own arc reactor from his chest to power his new suit, leaving Stark to die. Using his first reactor, which was not designed to power his latest armor, Stark battles with Stane atop Stark Industries and the surrounding streets, defeating him when the full-sized arc reactor that powers the lab is deliberately overloaded by Potts. Afterwards, Stark's alter ego is dubbed "Iron Man" by the press. Stark holds a press conference where his S.H.I.E.L.D. contacts advise him to state that Iron Man is Stark's bodyguard (the cover story used for years in the comics). However, he instead announces that he is Iron Man.

After the credits, S.H.I.E.L.D. director Nick Fury visits Stark some time later to discuss the Avenger Initiative.