He issued a plea for political unity while embracing liberal causes such as immigration reform, gay rights and the fight against climate change.
Mr Obama, 51, who is the 44th US president, was sworn in for his second term by Chief Justice John Roberts.
Hundreds of thousands of people crammed the ceremony on the National Mall.
Former Presidents Bill Clinton and Jimmy Carter, along with dozens of senators, congressional leaders and other dignitaries, attended the event at the US Capitol.
'Steeled resolve'
In his inaugural address, the Democratic president laid out his vision for the next four years and repeatedly declared: "Our journey is not complete."
"This generation of Americans has been tested by crises that steeled our resolve and proved our resilience," he said. "A decade of war is now ending. An economic recovery has begun. America's possibilities are limitless."
He added: "My fellow Americans, we are made for this moment, and we will seize it - so long as we seize it together."
In a roughly 18-minute, 2,100-word speech, Mr Obama called for "collective action" to preserve American freedom, which he linked to social and economic equality.
"We, the people, understand that our country cannot succeed when a shrinking few do very well and a growing many barely make it," he said.
In an era of congressional deadlock, the president said Americans must make hard choices to reduce the deficit and debt.
But he defended costly federal healthcare programmes which Republicans want to pare back. "These things do not sap our initiative, they strengthen us," he said.
And after four years of hyper-partisan struggle, during which he has repeatedly tussled with conservatives, he challenged Washington to change the tone of its politics.
"We cannot mistake absolutism for principle, or substitute spectacle for politics, or treat name-calling as reasoned debate," he said.
Without making specific policy recommendations, Mr Obama said the US must overhaul the tax code, reform its education system, revamp the voting system and address climate change.
"Some may still deny the overwhelming judgment of science, but none can avoid the devastating impact of raging fires, and crippling drought and more powerful storms," he said.
Mr Obama also referred to his just-launched campaign to curb gun violence.
"Our journey is not complete until all our children, from the streets of Detroit to the hills of Appalachia to the quiet lanes of Newtown, know that they are cared for, and cherished, and always safe from harm," he said, naming the town in Connecticut where 20 children were massacred in a shooting at a primary school last month.
Mr Obama also said there was a need to "find a better way to welcome the striving, hopeful immigrants who still see America as a land of opportunity."
As he was sworn in, Mr Obama placed his left hand on bibles owned by legendary American civil rights leader Martin Luther King Jr and President Abraham Lincoln.
Vice-President Joe Biden publicly took the oath as well.
Mr Obama was also sworn in at a small White House ceremony on Sunday, as the US Constitution dictates presidential terms begin on 20 January.
After Monday's speech, Mr Obama attended the traditional inaugural lunch, dining on bison and lobster with US lawmakers in the Capitol building's Statuary Hall.
The president's motorcade then set off on the parade route down Pennsylvania Avenue toward the White House. The president and first lady emerged from the limousine to walk part of the route hand in hand.
The zone surrounding the National Mall in the US capital was in virtual lockdown, with movement of people and vehicles tightly restricted.
White tents, trailers and generators lined the parade route, while nearby buildings were adorned with red, white and blue bunting.
Officials estimate about 700,000 people were to attend the inauguration, down significantly from 2009, when about 1.8 million people witnessed Mr Obama be sworn in as America's first black president.
In the evening, the Obamas will don formal evening attire for two inaugural balls in Washington, where 40,000 people are expected to attend.
About 260,000 people attended George W Bush's second inauguration ceremony in 2005.
From: BBC
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