In 2008, 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, his 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 and 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 Stark refuses. Enraged, Raza orders Stark's death. Upset, Yinsen builds a suit of armor and escapes in the night. The next day, Rhodes finds Yinsen and learns of Stark's death. In the night, Rhodes and US Air Force officers invade the cave, discovering and taking Stark's body.
Using notes, Rhodes and Stark's assistant Pepper Potts create arc reactors and with them being majority stake holders, announce that Stark Industries will cease manufacturing weapons. Obadiah Stane, Stark's father's old partner and the company's manager, advises them that it might ruin the Starks' legacy. At Stark's workshop in Malibu, they build a sleeker, powerful version of the Arc Reactors and armored suits. Believing Stark's death is the military's fault, Rhodes quits his job at the U.S. Air Force. Happy Hogan, feeling his job isn't needed without Star k, quits his job at Stark Industries and informs Potts and Rhodes he has accepted Rhodes' old position in the U.S. Air Force.
At a charity event held by Stark Industries, reporter Christine Everhart informs Rhodes and Potts that the company's weapons were recently delivered to the Ten Rings and are being used to attack Yinsen's home village, Gulmira. Enraged, Rhodes and Potts don their new armors (red and gold with blue streaks and blue and yellow, respectively) and fly to Afghanistan, where they save the villagers. While flying home, Rhodes and Potts are attacked by two F-22 Raptors. They reveal their secret identities to Hogan over the phone in an attempt to end the attack. Meanwhile, the Ten Rings gather the pieces of Yinsen's prototype suit and meet with Stane, who has been trafficking arms to the Ten Rings and has staged a coup to replace Stark as Stark Industries' CEO by hiring the Ten Rings to kill him. He subdues Raza and has him and the rest of the group killed. Stane has a massive new suit reverse-engineered from the wreckage. Seeking to track the company's movements, Rhodes and Potts hire Rhodes' assistant, Bambi Arbogast, to hack into its database. She discovers that Stane hired the Ten Rings to kill Stark, but they initially reneged when they realized they had a direct route to Stark's weapons. Arbogast meets with Agent Phil Coulson of S.H.I.E.L.D., an intelligence agency, to inform him of Stane's activities.
Stane's scientists cannot duplicate the miniaturized Arc Reactors, so Stane ambushes Rhodes and Potts at their home and steals the new arc reactor. They use their original Arc Reactors to replace the original. Arbogast and several S.H.I.E.L.D. agents attempt to arrest Stane, but he dons his suit and attacks them. Rhodes and Potts fight Stane but they are outmatched without their new reactors to run their suits at full capacity. The fight carries Rhodes, Potts, and Stane to the top of the Stark Industries building, where Rhodes and Potts order Arbogast 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, Rhodes and Potts publicly admit to being the superheroes, "Iron Man" and "Iron Woman", respectively.
In a mid-credits scene, S.H.I.E.L.D. director Nick Fury visits Rhodes and Potts at home, telling them that Iron Man and Iron Woman are not "the only superheroes in the world" and explaining that he wants to discuss the Avengers Initiative. In a post-credits scene, Rhodes and Potts approach General Thaddeus "Thunderbolt" Ross at a local bar and inform him that a team is being put together.