The Stark Arc Reactor is most likely a Multi-Isotope Radio-Decay Cell.

Since this is a fictitious device, and it has no "official" scientific explanation in the Iron Man
canon that I'm aware of, I'm going to make something up. I'm mixing real science and fake
science here. Physics nerds and comic-book nerds, deal with it.

Let's look at what we know about the arc reactor from movies 1 and 2:

Mk 1 Arc Reactor.jpg

The full-sized arc reactor looks a lot like a toroidal "Tokomak" plasma
containment system for standard "hot fusion":
Tony Stark (L) and Obadiah Stane (R) in front of Stark Industries' arc reactor

Real world equivalent: ITER fusion reactor

Fusion Energy Division

This type of fusion reactor exists today at research pilot scale. The reactor pictured, ITER, is
under construction and is planned to be the first fusion reactor large enough to produce a
net gain of energy. Basically, it mashes two isotopes of hydrogen, deuterium and tritium,
together at such high energies that they combine into one atom. When they fuse, the
reaction produces helium and a free neutron. Critically, helium+neutron has less mass than
deuterium+tritium, and the missing mass is converted to energy. That energy can be
captured as heat to run a traditional steam-driven turbine (like any other power plant).

So what does the arc reactor's torus (donut) shape tell us? It means there are charged
particles moving in a circle, contained by a magnetic field. High-energy particles usually
have high energy because they're moving very fast, and magnetic fields can curve the motion
of charged particles. Curving the particles' motion into a circle keeps them in one place long
enough to get them to collide.
You may notice that current fusion reactor designs have a lot of magnet coils on the outside
of the torus, whereas the Stark Industries arc reactor has a viewing window. Plasma
containment is the single biggest challenge for hot fusion, but the arc reactor makes it look
effortless. From this, we can conclude that a key technology in the full-scale arc
reactor is a way to contain the reaction in a self-sustaining ring. This line of
reasoning is definitely backed up by the toroidal field lines drawn in the Stark Industries arc
reactor blueprints:

Iron Man 2 - Arc Reactor.jpg

There is also a remarkable lack of cooling loops, turbines, or anything that a traditional
thermal reactor would require. Which means the arc reactor produces electricity
directly, rather than by first generating heat. This observation jives with the fact that
the megawatt-scale reactor in Tony's chest does not roast him alive. So it cannot be a hot-
fusion reactor, or a traditional thermal-fission reactor. Back to the drawing board!

What else do we know about the miniature arc reactor?

Contains a palladium core

The palladium is damaged by neutrons, so the specific isotope is important
Has electromagnetic coils in a torus
Emits blue-white light
Can be built in a cave with tools of moderate complexity
Requires no exotic materials outside what you could scavenge from dismantled
conventional weapons systems
 Runs low on power at inconvenient times, meaning it must have some sort of fuel or
consumed charge

Palladium has been proposed as a substrate for "cold" fusion that does not require hot
plasmas and containment toroids, but this concept is pretty widely discredited in the real
world. Palladium does, however, have some interesting capture and decay properties.
Wikipedia: Isotopes of palladium

Palladium isotope Pd-103 produces Rh-103 (rhodium) via electron capture. This means
an inner electron is absorbed by the nucleus, merging with a proton to produce a neutron
and an energetic photon -- a gamma ray.

Another isotope, Pd-107, produces Ag-107 (silver) via beta decay, releasing an
electronwhen a neutron turns into a proton. (This is kind of the opposite reaction as the
above.) Now, in real-world physics, the electrons balance the resulting atomic nuclei -- silver
and rhodium have different numbers of protons from palladium, and the
produced/consumed electrons just balance out the proton count so there is no net flow of
electricity.

I propose that Howard Stark found a way (using comic-book physics) to utilize
the beta decay of Pd-107 ions as an electron source for the electron capture of
Pd-103, thereby producing an electric circuit between two different radioactive
isotopes. Pd-103 is very radioactive (17 day half-life) compared to Pd-107 (6.5 million year
half-life) so there would need to be dramatically more of the heavier isotope to compensate
for the disparity in decay rates.

The palladium core of the device would most likely be Pd-107, which emits high-energy
electrons as it decays into silver. This is a pretty stable isotope that we would expect to be
present in the normal (non-separated) palladium that Tony might salvage from a
conventional weapon.

Since we know the device uses charged particles travelling within a ring of electromagnets, I
surmise that a tiny amount of Pd-103 is ionized by an electric arc (thus the reactor's name,
and start-up power requirement), which then allows Pd-103+ to be circulated at high
velocity within the outer ring of the device. The ionization acts to delay the electron capture
step until the atom encounters a free electron, and the high kinetic energy due to velocity
increases the chances of electron capture occurring once an electron is encountered. In
effect, the radioactive decay of Pd-103 can be started, stopped, and throttled by the device
simply by controlling the ionization and circulation of the Pd-103.

The device's geometry and electromagnetic fields route the high-energy electrons from the
Pd-107 core towards the outer ring. There, the electrons are captured by high-energy Pd-103
ions. This electron capture process emits gamma rays, which are deflected inward to
catalyze the beta decay of the Pd-107 core. We have some good evidence for this gamma ray
emission, because the suit's chestpiece unibeam weapon is clearly an emission of a large
number of high-energy photons directly from the arc reactor. Normally, the gamma rays are
directed inward to catalyze the device's operation, but they can be directed outward in a
concentrated energy beam weapon:

Sandman vs Iron-Man

So to summarize: electrons project outward from the inner core, and gamma rays project
inward from the outer ring. Because this electron/photon counterflow creates a deficit of
electrons (relative to protons) in the core, a massive electrostatic potential is developed and
the palladium core attracts lower-energy electrons from the suit's wiring. The ejection of
electrons from the core towards the rim of the device produces an electrical
cell capable of generating enormous voltage and current.

Here's the full proposed reactor start-up process:

Using external power, Pd-103 is ionized by an electric arc, and accelerated to high
velocity in the outer ring. There may also be some externally-powered gamma ray
production to jump-start the inner core.
Pd-107 in the inner core starts to emit high-energy electrons as it decays to Ag-107. The
electrons escape the core and are directed by magnetic fields into the outer ring. Lack
of electrons creates a net positive charge in the core, which slows further emission
(preventing run-away decay) until the electrons can be externally replenished.
In the outer ring, the high-energy free electrons collide with high-energy Pd-103+ ions.
This causes instantaneous electron capture and gamma ray emission. The gamma rays
are deflected inward towards the core, thus catalyzing further electron emission and
producing a self-sustaining reaction. Note that the reaction is self-sustaining, but very
slow while the reactor is idle.
The electron flow from the inner core to the outer core creates an electric potential
difference. When a circuit is created through the suit's electrical loads, the outer ring
has an excess of electrons and the inner core has a shortage of electrons. This creates
current.
The electrical current through an external load relieves the electrostatic charge
accumulations that initially slowed the reactions. So the less power the suit draws, the
slower the reactor produces radioactive decay, and the more power the suit draws, the
faster the reactions are catalyzed. That way, the power output automatically throttles
according to demand.
The palladium slowly converts to Rh-103 and Ag-107, and the reactor runs out of
power when the palladium is fully consumed.

Miniature Arc Reactor Concept:

Top view of my concept vs the Stark Industries blueprint, with cut-away side view below.

I can't speak for the next-gen "new element" arc reactor, but presumably, it replaces the
palladium isotopes with a hypothetical element that also undergoes gamma-ray-mediated
beta decay, but in a less-toxic and higher-output fashion.

Several other lines of evidence also support this type of nuclear decay / electron flux
reaction being the mechanism for the arc reactor. First, the reactor's glow:
Iron Man Arc Reactor

It could be caused by the ionization arc, but I think Cherenkov radiation is a much better
explanation. This is a special type of light emission that occurs when an energetic particle
(such as electron) enters a medium (like water or air) at a speed faster than the speed of
light in that medium. The high-energy electron flux within the arc reactor would be a
natural fit to generate this effect. This is a picture of an actual nuclear reactor producing
Cherenkov radiation:

Wikipedia

Notice the similarities? Unlike electrical arcs, the light from Cherenkov radiation is quiet,
cool-blue, and fricken' awesome. This is a no-brainer -- the arc reactor's glow is definitely
being produced by high-energy electron flux.

Another aspect of the original model palladium arc reactor was poisoning due to
"palladium toxicity." It's very possible that palladium is simply being ejected from the device
into Tony's blood by all the high-energy collisions going on, but this doesn't explain the
freaky circuit-looking lines on his chest, and it doesn't explain why doctors can't help him.
Palladium.jpg

I have a theory that fits the symptoms better. Remember, the proposed palladium
decay reactions produce rhodium and silver. Excess internal silver is known to stain
skin blue:

Discovery Health "Why can colloidal silver turn your skin blue?"

Rhodium compounds also stain skin, and are highly toxic. (Chemical properties, Health and
Environmental effects) In fact, because most people have essentially zero exposure to
rhodium, the toxicity of rhodium is very poorly-understood. This perfectly explains why
Tony didn't seek help from the medical establishment for his accumulated heavy metal
toxicity -- because he knew the doctors wouldn't know how to deal with rhodium
poisoning.Tony Stark didn't have simple palladium poisoning, he had
"palladium decay-product" poisoning!

So you see, everything fits together perfectly. The evidence all points towards the arc
reactor relying on a Pd-103/Pd-107 radio-isotopic decay cell to produce
electrical current. I will start working on my own arc reactor prototype and will post
updates when I produce a working replica.