Hamid Karzai called for unity among Afghans
Religious, academic and political leaders joined Kabul's growing band of foreign diplomats outside the presidential palace in biting cold weather for the occasion.
The flag has vertical bands of green, red and black with the legend "there is no God but Allah and Mohammad is his prophet".
It is modified from the horizontal stripes of the king's standard that was introduced in 1928 and banned 50 years later after the Soviet-backed communist takeover.
In the middle is the insignia in white of the "mehrab", the arch in the mosque where the prayer leader stands, and the "menber", a many-tiered pulpit, flanked by two flags and ensconced in two sheaves of wheat.
The flag also bears the words "the interim government of Afghanistan".
"Today marks a new era for our country. I hope my country will have peace forever," Mr Karzai said, before raising the flag as soldiers hoisted a larger version over one of the palace towers.
"We Afghan people have had many problems but from now on we must take each other's hands in a brotherly way and rebuild our country."
As an imam recited passages from the Koran in a rich, poetic baritone, Muslim guests held their hands out, palms facing heaven, praying for peace.
Continuing insecurity
Significantly, the ceremony was led by a woman - something unlikely to have happened under the Taleban's strict interpretation of the Koran which barred women from work or education.
The flag replaces the Taleban's plain white standard, which symbolised Islamic purity, though a variety of flags still fly around the country showing the divisions that remain.
The BBC correspondent in Kabul, Kate Clark, said Afghans in the capital hoped the red, green and black flag would help foster national unity after so many years of civil war.
But more important to them were two main concerns: the dire state of the economy and continuing insecurity.