The Arabic text is a google translation of "Islamic State of Iraq" (using the preposition "min" instead of "fi" for "of"), with the word "Iraq" broken up into two lines to fit into the grey circle, also the leading alif was probably lost in copy-paste into the graphics program) Supposedly based on a photograph formerly hosted at http://www.homelandsecurityus.net/v1.jpg (now a dead link) The uploader provided the following "Description of the photograph:"

U.S. soldier holds up the flag of The Islamic State of Iraq found in a Sunni village in Diyala province. The Islamic State of Iraq is an al Qaeda front group masquerading as a "shadow government". The above photo was posted at an internet forum by a jihadi as evidence of al Qaeda's future victory in Iraq.

since the same caption is found verbatim e.g. here showing a photograph with just the regular jihadist flag with the shahada, this image is presumably the result of some kind of weird misunderstanding.