The small RNA-directed viral immunity pathway in plants and invertebrates begins with the production by Dicer nuclease of virus-derived siRNAs (viRNAs), which guide specific antiviral silencing by Argonaute protein in an RNA-induced silencing complex (RISC). Molecular identity of the viral RNA precursor of viRNAs remains a matter of debate. Using Flock house virus (FHV) infection of Drosophila as a model, we show that replication of FHV positive-strand RNA genome produces an approximately 400 bp dsRNA from its 5' terminus that serves as the major Dicer-2 substrate. ViRNAs thus generated are loaded in Argonaute-2 and methylated at their 3' ends. Notably, FHV-encoded RNAi suppressor B2 protein interacts with both viral dsRNA and RNA replicase and inhibits production of the 5'-terminal viRNAs. Our findings, therefore, provide a model in which small RNA-directed viral immunity is induced during the initiation of viral progeny (+)RNA synthesis and suppressed by B2 inside the viral RNA replication complex.