The pirate flag is a symbol of identification used by pirates. This one in particular, was owned by the famous pirate LeBorgne. The flag is also a sign of identification amongst the rebels agains FunFrock's dictatorship.
To get to Rebellion Island, Twinsen needs to attach the pirate flag to the catamaran, or else the rebels in the island will shoot him at sight. Twinsen infiltrates the Maritime Museum, where the flag is exhibited and steals it. Once he attaches it to the catamaran, he can travel to rebellion island without a problem, since they will identify him as an oponent to FunFrock's tirany.
Inventory Description[]
"Pirate Flag. You can attach it to a boat."