The actual role of transition metals like iron in the room temperature ferromagnetism (RTFM) of Fe doped ZnO nanoparticles is still an unsolved problem. While some studies concluded that the Fe ions participate in the magnetic interaction, others in contrast do not believe Fe to play a direct role in the magnetic exchange interaction. To contribute to the understanding of this issue, we have carefully investigated the structural, optical, vibrational and magnetic properties of sol–gel synthesized Zn_1−xFe_xO (0 < x < 0.10) nanoparticles. No Fe²⁺ was detected in any sample. We found that high spin Fe³⁺ ions are substitutionally incorporated at the Zn²⁺ in the tetrahedral-core sites and in pseudo-octahedral surface sites in ZnO. Superficial OH⁻ was observed in all samples. For x ≤ 0.03, an increment in Fe doping concentration decreased a and c lattice parameters, average Zn–O bond length, average crystallite size and band gap; while it increased the degree of distortion and quadrupole splitting. Undoped ZnO nanoparticles exhibited very weak RTFM with a saturation magnetization (M_s) of ∼0.47 memu g⁻¹ and this value increased to ∼2.1 memu g⁻¹ for Zn_0.99Fe_0.01O. Very interestingly, the M_s for Zn_0.99Fe_0.01O and Zn_0.97Fe_0.03O increased by a factor of about ∼2.3 by increasing annealing for 1 h to 3 h. For x ≥ 0.05, ferrimagnetic disordered spinel ZnFe₂O₄ was formed and this phase was found to become more ordered with increasing annealing time. Fe does not contribute directly to the RTFM, but its presence promoted the formation of additional single charged oxygen vacancies, zinc vacancies, and more oxygen-ended polar terminations at the nanoparticle surface. These defects, which are mainly superficial, altered the electronic structure and are considered as the main sources of the observed ferromagnetism.