Somewhere inMoscow,Russia, a dying old man watches on TV the press conference of Tony Stark revealing himself to be Iron Man. He calls out his sonIvan Vanko(Mickey Rourke) and tells him with his last breath that he passes his knowledge to him. It is revealed that the old man had blueprints of theArc Reactor. Using the blueprints, Ivan builds his own Arc Reactor, along with a pair of arm-mounted electrified whips powered by it.
Six months later, Tony Stark (Robert Downey Jr.) has used his Iron Man armor as a nuclear deterrent, and a means of maintaining world peace. He opens the Stark Expo inFlushing,New York, to continue his father's legacy. Tony is still vilified by the United States government, and Senator Stern (Gary Shandling) in particular, who demands that he hand his armor technology over to the United States government, for military application. Stark refuses, publicly shaming rivalJustin Hammer(Sam Rockwell) in demonstrating how rival states and groups are at least five years away from successfully recreating the technology.
All is not well in Tony's life: he has discovered that thepalladiumin the Arc Reactor keeping his heart beating has begun to leak into his body and is poisoning him, raising his blood toxicity levels and slowly killing him. All attempts to find a substitute element have failed. Slowly going off the rails as a consequence of what he believes to be his impending death, he appoints his former personal assistantPepper Potts(Gwyneth Paltrow) CEO of Stark Industries, replacing her withNatalie Rushman(Scarlett Johansson).
While racing his own team's Formula 1 car at inMonaco, Tony is attacked by Ivan, but he shortly defeats him with the aid of his Mark V armor (a transforming briefcase). Tony discovers that Ivan is the son of disgraced Russian physicist Anton Vanko, who collaborated on the first Arc Reactor with Tony's father Howard (John Slattery) following his defection from theSoviet Union. Anton had wanted to use the Arc Reactor to earn money, and so Howard had him deported back to Russia, where he subsequently died in poverty and passed on the technology to his son, who swore revenge against the Stark family. Ivan is promptly broken out of jail by a revenge-seeking Justin Hammer, who puts him to work fashioning a line of "Hammer battle suits" that he will use to upstage Tony at his own Expo and fulfill his military contracts. Ivan decides to transform these battle suits into "Hammer drones", replacing the helmet assemblies with drone heads.
With the government coming down on him even harder, Tony throws what he believes will be his last birthday party and proceeds to get drunk whilst wearing the Iron Man Mark IV armor, becoming a danger to himself and others. His friend Lt. ColonelJames "Rhodey" Rhodes(Don Cheadle) is forced to wear the Mark II armor and subdue him, after which he confiscates the armor for the military. The disgraced Tony is approached byNick Fury(Samuel L. Jackson) ofS.H.I.E.L.D., who reveals Natalie to be an undercover S.H.I.E.L.D. agent named Natasha Romanoff, assigned to keep an eye on him. Fury also reveals that Howard Stark was a founding member of S.H.I.E.L.D. and provides Tony with a chest of his father's old artifacts that can hopefully be used to find a cure for his palladium poisoning, thus completing his father's unfinished work on Arc technology. Reviewing the film reels in the chest, Stark discovers a message from his father that leads him to the original diorama of the 1974 Stark Expo: in reality, a disguised diagram for the atomic structure of a new element. Tony hand-builds a particle accelerator in his home with the aid of his computerJ.A.R.V.I.S.(voiced byPaul Bettany) and synthesizes this new element. The newly synthesized element is then loaded into a modified Arc Reactor chest piece, and cures Stark's palladium poisoning. Ivan then calls Tony and taunts him, revealing that he is still set on revenge and plans to assault the Stark Expo.
At Stark Expo, Hammer unveils his new military drones, captained by Rhodey in a heavily-weaponized version of the confiscated Mark II armor, now referred to as the Variable Threat Response Battle-suit. Tony arrives at the expo in his new Mark VI armor, attempting to warn Rhodey, but Ivan takes complete control of both the drones and Rhodey's new armor and attacks Tony. As Tony battles against these remote-controlled enemies, Pepper has Hammer arrested by theNYPDafter he reveals the location of Ivan.Happy Hogan(Jon Favreau) and Natasha race to Hammer'sQueensfacility to stop Ivan. By the time they arrive, Ivan has already left the premises.
Tony battles Rhodey in a Japanese garden within the expo grounds after losing a few drones during the chase. During the fight, Natasha is able to hack through Ivan's control terminal and gives Rhodey control of his armor again so that he and Tony can fend off against the drones together. The two armored allies are surrounded by Hammer's drones, but they quickly defeat them.
They then confront Ivan, who has developed a powerfulsuit of armorfor himself based on a Hammer battle suit but incorporating upgraded versions of his Arc Reactor and whips. After a short but intense battle, the duo defeat Ivan. With his dying breath, Ivan tells the duo they lose, revealing that his armor and the drones have been rigged to self-destruct. As they leave the premises, Tony grabs Pepper and saves her from the explosion that destroys the expo. Stressed out by the situation that occurred, Pepper quits her CEO position, and the two finally kiss. Rhodes leaves with the War Machine armor despite Tony's objection, determined to keep the armor for national security purposes.
At a private debriefing, Fury gives Tony his assessment for the"Avengers Initiative", based on Natasha's report. Despite not recommending Tony to the project, S.H.I.E.L.D. wants Iron Man as a consultant. Tony agrees on the condition that Senator Stern be chosen to present him and Rhodes with their medals for bravery from the U.S. government.
In apost-credits scene, S.H.I.E.L.D. Agent Phil Coulson (Clark Gregg) drives to a remote impact crater in theNew Mexicodesert. He then informs Fury over the phone that they've "found it" as the camera zooms toThor's hammer in the center of the crater.