I think a combination of all the current national flags (or at least the obvious ones to start with, and maybe add them in per players requests as needed... No point writing code and resources for an andorran or morroccan flag if no one will ever use it!) and a customizable but somewhat rigid heraldic system like Potjeh suggests would work nicely. No one would be forced to fly a flag, but you could do what you like. People could fly whatever flags they wanted (i'd probably fly a us flag and maybe a german one, fwiw) to identify what language they speak or where they're from. If you feel like a goof and want to use up materials, you could make your village look like the dang UN building in new york city!
The heraldic thing could be used to display easily what kind of player you are or which in-game clan/group you identify with. I suppose if the heraldry is "locked", so that you put in whatever parameters you want by answering questions or whatever, and a device is autogenerated for you, it would make it a much more reliable and solid system for communication. Not saying I'd particularly LIKE it that way, but....
As far as flags adding to the "racism" in the game, i don't buy it. Bigots and stupid children will always find a way to express their moral crapitude. There's no point curtailing our own fun to try and avoid it. Just look at parchments and runestones...