Nicaragua's flag belongs to a family. The blue and white bands go back to the Federal Republic of Central America, which lasted from 1823 to 1841 and left its colors on most of the region's flags. Nicaragua adopted the current design on September 4, 1908, and made it official in law on August 27, 1971.
From Spanish emblems to Central American blue and white
Under colonial rule Nicaragua used Spanish emblems. After independence in 1821, and through the short life of the Federal Republic, Nicaragua and its neighbors flew blue and white stripes. Designs shifted with the country's politics through the 19th century, and the 1908 adoption was a deliberate return to that earlier visual identity. The 1971 decree changed nothing about the look of the flag, it simply put the 1908 design on a proper legal footing and pinned down the drawing of the arms.
The stripes and the coat of arms
Blue at the top and bottom, white in the middle, with the national coat of arms centered on the white band. The blue stripes are the Pacific and the Caribbean, the two coasts that bound the country. The white is peace, at home and with the neighbors.
The coat of arms carries most of the meaning. A triangle stands for equality and a rainbow for liberty. Five volcanoes inside the triangle represent the five Central American countries that stood together against oppression. Around them, in a gold circle, runs the motto "Republica de Nicaragua". The debt to the United Provinces of Central America is plain enough.
Flying it
The flag is displayed at government buildings, schools, and national celebrations such as Independence Day, raised at sunrise and lowered at sunset. Protocol is strict at presidential inaugurations and at international events where Nicaragua is represented. Military branches use variants with small modifications, keeping the core design intact so the flag stays recognizable.
The regional resemblance
El Salvador and Honduras carry much the same blue and white, and for the same reason: all three were part of the Federal Republic of Central America, and all three kept the colors after it broke up.
References
[1] Government of Nicaragua: Official Flag Description (http://www.presidencia.gob.ni)
[2] "Flags of the World" - Nicaragua Section (http://www.crwflags.com/fotw/flags/ni.html)
[3] Vexillology Organization Reports - Central American Flags (http://www.vexillology.org)