On 20 September 1916, No. 2 Squadron was established as a unit of the Australian Flying Corps (AFC) at Kantara, Egypt, drawing personnel mainly from Australian Light Horse units of the Australian Imperial Force (AIF). Shortly after forming, under the command of Major Oswald Watt, the unit was transferred to the United Kingdom to complete training, arriving at Harlaxton on 30 January 1917. Between February and September 1917, the squadron undertook training with Royal Flying Corps units before being equipped with Airco DH.5 fighters. To differentiate the squadron from the British No. 2 Squadron RFC, it was known to the British military as "No. 68 Squadron RFC". This terminology was never accepted by the AIF who continued to use the AFC designation regardless, and by January 1918 the British designation was officially discontinued.
In late September 1917, the squadron flew its aircraft across the English Channel, landing in St Omer without incident or loss – and after overnighting there it moved to Baizieux. Assigned to the 13th Army Wing, RFC, it undertook its first combat operations on the Western Front a month later. Its first major action came during the Battle of Cambrai in November and December when it was heavily involved as a low-level ground attack unit, attacking German trenches, but suffering heavy casualties in doing so. On 22 November, the squadron shot down its first German aircraft in air-to-air combat during a chance encounter on a ground attack sortie. After this, several more German aircraft were shot down by the squadron's pilots before the squadron was withdrawn from operations in December to re-equip with Royal Aircraft Factory S.E.5a fighters. In January 1918, the squadron moved to Savy, and the following month gained its first victories with the new aircraft type.
During early 1918, the Germans launched a major offensive on the Western Front after the collapse of Russia allowed them to increase their forces in the west. Falling initially against the British southern flank, the offensive pushed the Allies back significantly, and the squadron was forced to withdraw to airfields further back from the front as German forces advanced steadily: in March it moved to La Bellevue and then to Fouquerolles, remaining there until June when it moved to Liettres to support the French during the Marne offensive. During this time, the squadron was attached to the Royal Air Force's Nos 10, 22, 51 and (finally) 80 wings. Despite the moves, the squadron maintained a high operational tempo, becoming involved in heavy air-to-air combat during fighter sweeps, and also being used to attack advancing German ground forces (see image left). After the German offensive was finally halted, the Allies launched their own offensive in August around Amiens after which the squadron was employed to attack German airfields, and as the Germans were forced back, attacking withdrawing German troops on the ground. Throughout October, in an effort to keep up with the advance, the squadron moved three times and by the time the armistice was signed in November it was based at Pont-a-Marq.
Following the conclusion of hostilities, the squadron was withdrawn to the United Kingdom in March 1919 as the demobilisation process began. On 6 May its personnel embarked on the transport Kaisar-i-Hind for repatriation back to Australia, at which time the squadron was disbanded. During the war, No. 2 Squadron produced 18 flying aces, including Francis Ryan Smith, Roy Cecil Phillipps (the squadron's highest scorer), Roby Lewis Manuel, Henry Garnet Forrest, Adrian Cole, Eric Douglas Cummings, Richard Watson Howard, Frank Alberry, Ernest Edgar Davies, and James Wellwood. The squadron's total score was 94 aircraft shot down, 73 out of control and 18 driven down. Its casualties amounted to 25 personnel killed and eight wounded.
In 1922, No. 2 Squadron was briefly re-formed as part of the newly independent Royal Australian Air Force at Point Cook, Victoria, but it never progressed beyond a cadre unit and was disbanded a few months later.