The Signal Flag is one of the three objects the Pilgrims lost. It was stolen by unknown thieves (possibly the Purple Giant), and was hidden on the top of the water tower. To get up there, you need the Jet Pack from the Aircraft Graveyard. After you give it back to the Pilgrims, the Royal Sailor ship sees the flag and docks at the port. He will then award you with credits and the Island Medallion.