Palau was initially settled around 1000 BC.

Palau was likely sighted for the first time by Europeans as early as 1522, when the Spanish mission of the Trinidad, the flagship of Ferdinand Magellan's voyage of circumnavigation, sighted two small islands around the 5th parallel north, naming them "San Juan" without visiting them.

Palau was subsequently 'discovered' by the Europeans on 28 December 1696 when the first map of Palau was drawn by the Czech missionary Paul Klein based on a description given by a group of Palauans shipwrecked on the Philippine coast on Samar. This map and a letter sent to Europe by Klein in June 1697 had a vast impact on interest in Palau. It resulted in the first Jesuit attempts to travel to the islands from the Philippines in 1700, 1708 and 1709, which failed to establish missions. The islands were then visited by the Jesuit expedition led by Francisco Padilla on 30 November 1710, who left two priests Jacques Du Beron and Joseph Cortyl stranded on the coast of Sonsorol, while the mother ship Santissima Trinidad was swept away by a storm. Subsequent attempts to save Du Beron and Cortyl revealed that they were killed and eaten by the locals.

After further attempts, the Palau islands were made part of the Spanish East Indies in 1885. Following Spain's defeat in the Spanish–American War in 1898, the islands were sold to Imperial Germany in 1899 under the terms of the German–Spanish Treaty, with Palauan islands administered as part of German New Guinea. British traders became prominent visitors in the 18th century, followed by expanding Spanish influence in the 19th century. After defeat in the Spanish–American War, Spain sold Palau and most of the rest of the Caroline Islands to Germany in 1899. Control passed to Japan during World War I. In the course of World War II the islands were taken by the United States in 1944. The Battle of Peleliu between September 15 and November 25 1944 was hard fought, with 2,000 Americans and 10,000 Japanese killed. The islands passed formally to the United States under United Nations auspices in 1947 as part of the Trust Territory of the Pacific Islands.

Four of the Trust Territory districts formed a single federated Micronesian state in 1979, but the districts of Palau and the Marshall Islands declined to participate. Palau, the westernmost cluster of the Caroline Islands, instead opted for independent status in 1978, approved a new constitution and became the Republic of Palau in 1981, and signed a Compact of Free Association with the United States in 1982. After eight referendums and an amendment to the Palauan constitution, the Compact was ratified in 1993 and went into effect on October 1, 1994, marking Palau independence de jure (after Palau was independent de facto since May 25, 1994, when the trusteeship was cancelled).

Legislation making Palau an "offshore" financial center was passed by the Senate in 1998. In 2001, Palau passed its first bank regulation and anti-money laundering laws.