The film opens in Moscow where an old man dies while watching the press conference from the last movie live on television where Tony Stark (Robert Downey Jr.) reveals that he is Iron Man. He is Ivan Vanko’s (Mickey Rourke) father. Ivan, in a mournful rage, begins designing a new suit for himself in a similar vein as Iron Man’s. As this montage plays, we see he has a parrot and the room is littered with newspaper and magazine articles on Tony Stark. He builds an arc reactor similar to the one on Tony’s chest.
It’s six months later, Iron Man jumps out of a plane and rockets down to the ground as fireworks blast around him. He lands in a stadium in Flushing, New York. It’s Stark Expo. He’s surrounded by a cheering crowd and sexy dancing ladies as a machine takes the Iron Man suit off revealing Stark in a suit as loud AC/DC music plays. Stark makes a speech welcoming people to Stark Expo where he mentions how the world is facing unprecedented peace thanks to his role as Iron Man. He introduces a video of his father, Howard Stark talking about world peace and showing a model of “the city of the future”. Outside the event, Tony maneuvers his way through a crowd and is served a subpoena to show up to the Senate Arms Services Committee.
At the hearing, Senator Stern (Garry Shandling) goes after Stark hard and wants the Iron Man technology to be handed over the United States government. Also at the hearing is Justin Hammer (Sam Rockwell) as an expert on weapons technology for the United States government and a business rival of Stark’s. Also called to the hearing is James Rhodes (Don Cheadle) to Stark’s surprise. He testifies that the Iron Man could be a threat to national security. Rhodes shows satellite pictures showing attempts at the Iron Man technology in enemy countries. Tony, however, pinpoints the footage and sabotages the technology right there including some of Hammer’s own weapons. To the entire Senate chamber, he declares that he has privatized world peace and that the world is safe now thanks to him.
Back in Moscow, Ivan watches angrily and destroys the television with his new Whiplash suit. Stark, in his lab, tests his blood and finds that he may be sick. The Iron Man suit is accelerating his “condition”, according to Jarvis. The reactor in his chest that is keeping him alive is also slowly killing him. Pepper Potts (Gwyneth Paltrow) comes into Stark’s lab angry that he has donated his art collection to Boy Scouts of America. She also argues that the Expo was a big waste of time. Stark doesn’t want to deal with the boring day to day business of Stark Industries so he makes Pepper CEO and Chairman so she can actually run the entire company.
Stark spars with Happy Hogan (Jon Favreau) when Pepper comes in with Natalie Rushman (Scarlett Johannsen), an employee from legal, to sign some contracts officially signing over the company to Pepper. Natalie pulls some karate moves on Happy knocking him on his back. She intrigues Tony.
We cut to the Grand Prix in Monaco. Tony arrives to crowd cheers with Pepper and Happy meeting Natalie who is there as Tony’s new assistant. Justin Hammer is also there with Christine Everheart (Leslie Bibb), the reporter Tony slept with from the first movie. She is doing an article on Hammer for Vanity Fair. Hammer’s government contract has been put on “hold” because of what happened at the hearing. Tony pulls the Stark Industries driver and decides to drive the racecar himself. This draws all the attention on to Stark, to Hammer’s chagrin.
Ivan can be seen in the pit, dressed up as one of the crew guys. He walks his way on to the racetrack and uses his Whiplash technology to slice Tony’s car. Happy and Pepper take the car and rush to Stark hoping to get his Iron Man suitcase to him. After Tony crashes, many of the other cars on the racetrack become totaled as Hogan and Pepper dodge and weave through the racetrack trying to get to Tony in time. Tony tries to take Ivan on without the suit but he doesn’t do too well as he’s thrown against a car and catches on fire for a bit. Hogan and Pepper run their car into Ivan but he’s still alive and slashes and whips at the car slicing it in half. Pepper gets Tony the Iron Man suitcase in time and pushes them out of the way. At the end of the battle, Tony pulls the arc reactor out of his chest. The authorities drag him away as he laughs and Tony crushes the arc reactor in his hands.
Tony insists on having a private conversation with Ivan. Ivan taunts Stark, telling him it is because of Ivan’s father that Stark is alive. He seems to know about the condition that the arc reactor in his chest is causing and says it’s a painful way to die. Senator Stern on TV says that the Monaco incident shows that he was right that the Iron Man technology is out there and it is unsafe. Tony wants to go and get away from it all but Pepper insists it’s a bad idea because of the disarray the company is in.
Meanwhile, in prison, Ivan is given a plastic explosive and instructions to help him escape prison. He leaves a decoy body and as he escapes he is taken by people and put in a van. When he comes out, he finds that Justin Hammer has freed him from prison. Hammer was very impressed by Ivan’s attack on Stark. He offers Ivan resources to not just destroy Tony Stark but to destroy the Stark legacy. Ivan wants his bird.
Stark learns more about Ivan’s father. Ivan’s father was a Soviet physicist who defected to America but was accused of espionage and deported. Ivan is also a physicist who was sent to prison for selling weapons to Pakistan. Rhodes tries to get Tony to deal with the government who want to take his suits and technology away. Tony collapses due to a damaged arc reactor and gets Rhodes to switch it out. He wants Stark to not keep trying to go it alone but Stark says he has to.
Hammer shows Ivan his prototype suits. To Hammer’s dismay, Ivan immediately begins tampering with the suits and computers. It’s Tony Stark’s birthday and he’s concerned that it may be his last. Natalie says that if it were her last birthday ever she would do whatever she wanted with whomever she wanted to do it with. Cut to Tony at his birthday party, manning the DJ booth in his Iron Man suit completely drunk. This concerns Rhodes and Pepper. Rhodes disgusted with Tony’s behavior rushes down to Tony’s lab and puts on one of Tony’s silver armored Iron Man suits. He demands Tony to shut down the party. Tony refuses and they get into a fight in front of all the party guests, who all eventually flee.
Tony and Rhodes both point there plasma beams at each other and fire simultaneously blowing the entire room apart. As Tony awakens, he sees Rhodey fly away in his Iron Man suit. Rhodey flies the suit back all the way back to his air force base. Tony, still in his armor, is eating donuts at Randy’s Donuts when Nick Fury (Samuel L. Jackson) shows up. He tells him that he still doesn’t want to join his team and Fury says he remembers that Stark wanted to play it alone. Fury reveals that Natalie is actually Natasha Romanoff, a SHIELD agent who was assigned to shadow Stark. Natasha injects him with something to help Stark with his condition. Fury says he can help him find a replacement for the reactor keeping him alive. Hammer brings Ivan a bird but Ivan insists it’s not his bird. Hammer notices that Ivan has completely redesigned the suits to not have people inside. He has redesigned them into drones. Rhodes shows his superiors the suit he stole. They are going to weaponize it and show it at Stark Expo. Nick Fury fills Stark in on Stark’s father’s role in deporting Ivan’s father to Russia. Fury knew Stark’s father and told him that he helped found SHIELD. He also tells him about how the reactor in his chest is unfinished. Fury leaves Stark with Agent Coulson (Clark Gregg) and some of his father’s old property to help him finish the arc reactor.
Hammer shows off his weaponry to Rhodes and the military. They are going to use these guns and modify them to the new stolen Iron Man suit. Stark opens up the case Fury left behind and finds blueprints, notebooks, and old film reels. In the old film reels, there is a message from Tony’s father to Tony. His father tells him about how he has left behind everything to him so one day he can truly change the world. His greatest lasting creation is Tony.
Stark goes to Pepper’s office to apologize but she refuses and tells him to leave. He sees the model future of the city from his father’s film reel and decides to take it back to his lab. After analyzing the model, he finds a framework for a new element that could potentially replace the element in his arc reactor. Agent Coulson returns and tells him that he has been re-assigned to New Mexico by Fury. Coulson finds a work-in-progress Captain America shield, which Stark uses as a leveler.
Stark creates a machine that helps him successfully create the new element, which fits into the reactor successfully. Hammer, angry with Ivan’s lack of progress, takes away Ivan’s bird in anger. Hammer says he doesn’t need Ivan’s drones anymore thanks to the Iron Man suit he got from the Rhodes and the military. Back at Tony’s lab, he gets a call from Ivan who has killed the guards Hammer put on him. He warns Tony that what his father did to his father, the world will soon do to him in less than an hour. Tony puts on his new reactor to great power.
Hammer makes his presentation at Stark Expo. He shows off his new army of drones, designed by Ivan, for the Army, Navy, Air Force, and the Marines. His final presentation is the War Machine suit with James Rhodes in the pilot seat. Tony Stark interrupts the presentation and confronts Hammer about working with Ivan. Ivan remotely takes over the drones and Rhodes War Machine Suit and starts firing at Tony who flies out through the roof. The drones and War Machine give chase with Rhodes unable to do anything inside. Meanwhile the drones march into the crowd. Pepper and Natasha confront Hammer about what is happening. Hammer tells them that it's Ivan who is behind it.
The drones begin attacking indiscriminately as Ivan watches on. Natasha commandeers Happy and his car to go after Ivan. Tony leads the drones and War Machine away from the Expo. Happy and Natasha break into Hammer headquarters and get into a fight with the guards. Ivan unleashes more drones. Tony destroys a whole bunch of drones by maneuvering through the World’s Sphere. Natasha and Happy find the room Ivan was working from but he is gone. Rhodes smashes into Tony knocking them both into a park. Natasha reprograms what Ivan did to War Machine and Rhodes is back into control. Natasha finds that all signs of Tony’s disease are gone and he is no longer dying. Rhodes and Tony apologize to each other as a whole swarm of drones approach their position. They are surrounded. A huge battle ensues between Iron Man and War Machine against the army of drones around them. Pepper directs the cops to arrest Justin Hammer. He swears revenge on her.
Natasha sees another drone approaching. This one is Ivan in a big new, improved armor suit that he had before. He attacks Stark and Rhodes. Ivan has Stark and Rhodes tied up in his whiplashes. They both fire at him with huge beams at the same time like before except this time at Ivan. It looks like it works until they find that his suit and all the drones are rigged to blow up. Tony rushes to Pepper and rescues her from an exploding drone just in time and flies her to a nearby roof. Pepper freaks out and threatens to quit. They kiss. Rhodes interrupts them and tells Tony that he’ll be hanging on to the suit and flies away.
Stark meets with Fury and they go over Natasha’s report on Tony. Fury’s conclusion is that they only want Tony as a consultant for their Avengers Initiative. They find him too unpredictable and don’t fully trust him, despite Stark’s protestations that he is in a stable relationship with Pepper and that everything is fine with him now. As one last favor, Fury pulls some strings to get Senator Stern to present Rhodes and Stark with awards.
After the credits, there’s a short scene showing Agent Coulson driving to a dig site in the middle of the New Mexico desert. He makes a phone call and says, “We’ve found it.” The camera pans back to reveal Mjolnir (Thor’s hammer) in the middle of the giant hole.
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