Palacios is on State Highway 35 halfway between Houston and Corpus Christi in the southwestern corner of Matagorda County. The town is also on Tres Palacios Bay (after which it is named), an inlet of Matagorda Bay off the Gulf of Mexico. The name of the bay is Spanish for "Three Palaces." An apocryphal story has it that sailors from a Spanish ship that wrecked in Matagorda Bay thought they saw palaces on the shoreline. As they neared the shore, however, the palaces disappeared. It is thought that the bay and the Tres Palacios River were actually named for José Félix Trespalacios. In 1901 the future site of Palacios was part of the bull pasture offered for sale by the estate of Abel H. (Shanghai) Pierce. The Texas Rice Development Company purchased the land and subdivided it into 160-acre tracts. The mile-square tract on Tres Palacios Bay at Hamilton Point was sold by the Palacios City Townsite Company, a subsidiary of the development company. The town of Trespalacios was surveyed into lots in 1902. Since there was already a nearby post office named Tres Palacios the new town changed its name to Palacios. The development company paid a bonus to the Southern Pacific to extend its line to Palacios.
In 1903 a post office was opened, the first church was organized, the train began excursions for settlers, and the townsite company built Hotel Palacios. In 1904 a pavilion was constructed on a T-head pier over the water at the south end of town, next to the hotel. The pavilion had bathhouses and was used for swimming, dancing, fishing, picnicking, skating, dominoes, and other entertainment. Fish and oyster businesses opened, and fishing remained a significant local enterprise into the 1990s. Promotional material for Palacios and the area touted the climate as favorable for raising peaches, figs, oranges, and other fruits, as well as for truck farming. In the town's early years cotton was an important crop, and by 1910 rice was being farmed locally. The townsite company gave thirteen acres on Hamilton Point to the Baptists on the condition that the Baptist Young People's Union Encampment would be held at Palacios. The first encampment was held there in 1906. In 1907 the Palacios public library was organized by five women; it was officially established in 1910 and in 1967 moved to the site it still occupied in the 1980s. In 1989 it had more than 42,000 volumes. By 1915 the town had a population of 2,000, more than 100 businesses, a weekly newspaper (the Beacon), and Baptist, Methodist, Presbyterian, and Lutheran churches. In 1926 a training camp, called Camp Palacios, was begun at the town for the Texas National Guard. In 1930 the camp was renamed Camp Hulen after John A. Hulen, commander of the Thirty-sixth Infantry Division. By the mid-1930s Palacios had two schools and a population of 2,288. The town reported 2,799 residents and ninety-three businesses in 1955.
As of 1990 Palacios had never had heavy industry, but it had grown steadily because of its proximity to a number of major industrial concerns: the Aluminum Company of America (Alcoa) in the 1950s, Celanese Chemical Company (1960s), and the South Texas Nuclear Project (1970s; later known as the South Texas Project). The nuclear plant employed more than 10,000 in 1985, and after construction was completed, more than 1,000 permanent employees remained. The South Texas Project is situated on land within the Palacios Independent School District, and the district, which served 1,700 students in 1989, benefits from that additional tax revenue. In 1988 the school district began the Palacios Marine Education Center; at that time the facility was the only one of its kind in Texas. In 1990 the marine and seafood-processing industry was the largest industry in the Palacios area. Numerous seafood-processing plants shipped fresh and frozen shrimp and crabmeat nationwide; these industries included the largest blue-crab-processing plant in the United States and the only IQF (instant-individual quick frozen) shrimp-processing plant on the Texas coast. At that time agriculture, the second largest local industry, produced cattle, rice, maize, cotton, soybeans, corn, and turf. Petroleum and natural gas were also a vital part of the Palacios area economy, and in 1990 aquaculture was the newest developing industry there.
Palacios is an incorporated city with a mayor-council government. The town hosts a number of annual festivals, including the Chamber of Commerce Fishing Tournament (August), the Bay Fest (October), and the lighting of the Christmas palm tree (December). In 1976 the Texas Baptist Encampment hosted the Young Men's Christian Association World Youth Peace Conference at Palacios. The Texas Baptist Encampment has been involved with Christian camping and in the 1980s could accommodate 500 people in its air-conditioned facilities. In 1989 Palacios was served by more than twenty area churches belonging to fourteen communions. In 1990 the town maintained nine parks, including three on the waterfront. Swamp Lots Park offered a natural estuary for the breeding of shrimp, fish, and waterfowl. Matagorda County Navigation District No. 1, located in Palacios, has three large turning basins, which in 1990 were home port to some 380 vessels and sixteen seafood businesses. The turning basins have easy access to the Matagorda Ship Channel, the Gulf Intracoastal Waterway, and the Gulf of Mexico. Just west of Palacios is the Texas Parks and Wildlife Department Marine Research Station. The Palacios seawall, constructed in 1935, has since been renovated, resupported, leveled, and capped, and concrete sidewalks with safety guardrails have been added around the shoreline. The seawall is lit at night. By 1989 Palacios had grown to a population of 4,603 and some seventy-seven businesses. In 1990 its population was 4,418. By 2000 the population was 5,153.