It's unclear at this point whether this was a creative, scheduling or financial decision, but there are some rumours - fuelled by his recent interview with MTV News - that he was growing frustrated at the lack of clarity over what a third chapter would bring to the table (current indications suggest a continuation of themes collected togther in Marvel's proposed mega team-up).
It has also been noted that Favreau's price-tag, up in the wake of the movies' own profits may also have played a part in the decision as Marvel and parent company Disney both have a reputation for keeping a tight hand on the purse strings of all their projects. The first two films may have brought in massive figures, but the production is not a cheap one either - Favreau rumoured to have around a $10 million paypacket for the first sequel. Marvel and Disney have begun looking for a new person to helm the third film but whoever they get will have to find favour with Robert Downey Jnr as the star has a contractual right to approve the man behind the camera.
Regardless of where things stand at this point or what may change/be confirmed in the months to come, Favreau and Downey Jnr are both booked up on other projects for some time and it seems unlikely that Iron Man 3 would even begin production until late 2012, whomever is aboard.
UPDATE: Favreau himself has confirmed he was off the project via Twitter late on 14th Dec, saying: " It's true, I'm directing Magic Kingdom, not Iron Man 3. I've had a great run with Marvel and wish them the best."