Six months after the end of the first movie, Tony Stark (Robert Downey, Jr.) has used his Iron Man armor to bring about a negotiated peace treaty between the major super powers of the world, and his immense popularity with the general public is only furthered when he fulfills his father’s dream by opening the “Stark Expo”, to showcase all the latest inventions that will benefit the world. Stark is, however, still vilified by the United States government, and Senator Stern (Gary Shandling) in particular, who demands that he hand his armor technology over for military application. Stark refuses, publicly shaming rival Justin Hammer (Sam Rockwell) in the process by highlighting his own failed attempts at recreating the technology. All is not well in Stark’s life, however: he has discovered that the palladium in the arc reactor keeping shrapnel from penetrating his heart has begun to poison his body, slowly killing him, and 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 assistant Pepper Potts (Gwyneth Paltrow) CEO of Stark Industries, replacing her with Natalie Rushman (Scarlett Johansson).
While racing in Monaco, Stark is attacked by Ivan Vanko (Mickey Rourke), who has constructed a miniaturized arc reactor of his own. It is contained in a chest harness with two attached whips, powered by the reactor’s energy. Vanko uses the whips to create a massive car crash in the race and goes after Stark. Stark is able to defeat Vanko with the aid of his Mark V armor (a transforming briefcase). Stark later discovers that Vanko is the son of disgraced Russian physicist Anton Vanko, who collaborated on the first arc reactor with Stark’s father Howard (John Slattery). Vanko is promptly broken out of jail by a revenge-seeking Justin Hammer, who puts him to work developing armored suits like Stark’s that he plans to unveil at the Stark Industries Exposition. Vanko, upon seeing the suits for the first time, forcibly removes the suit’s head, saying he can improve the design.
Tony throws what he believes will be his last birthday party and gets drunk whilst wearing the Iron Man armor. His subsequent reckless behavior prompts his friend, Lt. Colonel James Rhodes (Don Cheadle) to don the Mark II armor and subdue him. Rhodey flies off in the Mark II armor, delivering it to military authorities at Edwards Air Force Base. Justin Hammer is later invited to study the suit himself and provides them with advanced weapons to arm it with.
Disgraced, Stark is approached by Nick Fury of S.H.I.E.L.D (Samuel L. Jackson) who tells Stark that his father’s work went unfinished due to the technological limits of his time. They are joined by Natalie Rushman whom Fury reveals is, Natasha Romanoff, an undercover operative of SHIELD, planted to monitor Tony himself. She injects Tony with a serum that slows the symptoms of his palladium poisoning significantly, giving him the time to find an alternate element to keep him alive. Fury provides Tony with a chest of his father’s old artifacts that can hopefully be used to find a cure for his palladium poisoning. Reviewing the film reels in the chest, Stark discovers a message from his father that leads him to the original 1974 diorama of the Stark Expo: in reality, it is a disguised diagram for the atomic structure of a new element. Stark hand-builds a particle accelerator with the aid of his computer J.A.R.V.I.S. (voiced by Paul Bettany) and synthesizes this new element, creating a new triangular chest arc reactor that cures his poisoning.
At Hammer Industries, Vanko has radically changed the design of Hammer’s suits: they are now automated drones. Despite what Vanko considers improvements, Hammer is displeased and imprisons Vanko in a small room with two guards while he takes the drones to the Stark Expo.
Hammer unveils his new military drones, captained by Rhodes in a heavily-weaponized version of the confiscated Mark II armor. Unfortunately, it is soon discovered that Vanko has programmed the drones, giving himself complete control. He also has control of Rhodes’ new armor, and Stark arrives just as they go on the attack. As Stark battles these remote-controlled enemies, Happy Hogan (Jon Favreau) and Romanoff race to Hammer’s Queens facility to stop Vanko. By the time they arrive, Vanko has already departed for the Expo in a new armored suit, an updated version of the harness he used when attacking Tony in Monaco. Natasha is able to give Rhodes control of his armor again so that he and Stark can fight Vanko together. The two armored allies combine their powers and successfully take Vanko down, but his armor and drones are revealed to have been equipped with self-destruct charges. As they begin to explode, Stark races to save Pepper, rescuing her at the last minute. After landing on a roof she quits her CEO position, and she finally gives Tony a kiss, to which they both find Rhodes sitting a few meters away. He then claims he was there first so they should get their own roof after Stark tries to defend himself.
At a debriefing, Fury informs Stark that while Stark is “unsuitable” for the “Avengers Initiative”, S.H.I.E.L.D. wants Stark as a consultant. Stark agrees on the condition that Senator Stern personally present him and Col. Rhodes with their medals for bravery.
In a post-credits scene, S.H.I.E.L.D. agent Coulson (Clark Gregg) is seen driving to a remote impact crater in the New Mexico desert. As he informs Fury over the phone that they’ve “found it”, the crater is shown to contain Mjolnir, the hammer of Thor.