The murdered man's head was found attached to a wire mesh fence surrounded two flags - one black and one white - near the entrance to the Air Products factory in Saint-Quentin-Fallavier, police said.
According to Le Parisien newspaper, the man's face was covered in Arabic writing and there was speculation that he may have been murdered elsewhere and the body then taken to Air Products for the gruesome display. 
A man named as Yassin Salhi, aged 35 and from Saint-Priest in Lyon, was detained by firefighters at the scene and has been arrested.
Sources told the AFP news agency that his victim was Salhi's own manager at a delivery firm that did work for Air Products.
Authorities said the suspect had previously been under security service surveillance after fears he had been radicalised and had links to extremists.
Europe 1 radio carried a telephone interview with a woman which it identified as Salhi's wife.
She said that her husband had left for his delivery job this morning and she had heard nothing from him since. 
"What's happening here? My heart is going to break. It can't be him," she added. "We are normal family with children We live normally."
Asked if her husband was religious, she said: "Yes, we are muslims. But in a normal way. We respect Ramadan. No more than that."
It was later reported that Mr Salhi's wife and another person from the home where they lived with their three children had been taken into custody for questioning.
A timeline pieced together by French media after watching surveillance footage suggested Salhi arrived at Air Products in a van and put the head on the fence with the flags.
He then drove into the factory and crashed into a pile of gas cannisters, causing an explosion that was heard at 9.50am local time (8.50 BST).
The attacker then reportedly ran into Air Products in an attempt to cause more explosions with the gas and chemicals stored there but in that time, firefighters arrived to tackle the gas blaze.
They arrived to hear Salhi shouting 'Allahu Akbar!' (God is great) and managed to surround him and keep him there until police arrived to arrest him.
The decapitated victim, in his 50s, was reportedly the manager of a transport company in the Lyon area, which was subcontracted by Air Products.
There was continued confusion over why initial reports said there were two attackers in the car, but only one man has been arrested. 
Speaking from Brussels before returning to France, President Francois Hollande said one person had been killed and two injured in what bore all the "hallmarks of a terrorist attack".
He said there was "no doubt" the terrorists, one man and an accomplice, meant to cause an explosion at the factory using gas cannisters.
"There is emotion but emotion cannot be the only response. There must also be action, prevention, dissuasion," the President added.
"It is vital to further our values, to never to give in and never, whatever the circumstances, create unnecessary division or intolerable suspicion.
"We will ensure that the French people are protected and eradicate the groups or individuals responsible for these acts."
The French interior minister, Bernard Cazeneuve, spoke in Isère this afternoon, where he identified the suspect and said several other arrests have been made in relation to the investigation.
He said Salhi did not have a criminal record but had links to Salafists and was known to security forces since 2006, when they believed he had been radicalised. They stopped surveillance two years later.
Speaking from Brussels, where he is attending EU talks, David Cameron said terrorism is a "threat that faces all of us" and that attacks like those today in France, Kuwait and Tunisia "can happen anywhere".
"(We must) deal with the threat at source, whether that is Isil (Isis) in Syria and Iraq or other extremist groups around the world," the Prime Minister added.
"Perhaps more important than anything is this poisonous, radical narrative that is turning so many young minds. We have to combat it with everything that we have." 
He announced an an emergency Cobra meeting with ministers later today on counter-terrorism and intelligence sharing.
Air Products is headquartered in the US but is an international corporation with facilities in several countries, including the UK, mostly selling gases and chemicals for industrial use.
A spokesperson did not confirm whether its staff were among the two people reported injured and one dead but said the site had been evacuated.
He added: "Our crisis and emergency response teams have been activated and are working closely with all relevant authorities."
The vehicle used by the attacker belonged to a sub-contracting company which had a right to enter the site, according to Isere's Prefect, the senior national government administrator.
Jean-Paul Bonnetain said investigators were now looking at the possibility that the terrorists had first attacked Air Products or one of its employees and hijacked the vehicle.
France has been in a state of high alert since the attacks on the Charlie Hebdo offices and a Kosher supermarket in Paris.
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