There are various versions regarding the origin of the place name. According to one, Palai gets its name from Palazhi (Ksheera Sagara), the mythological ocean of milk from which nectar was churned out. Another view is that the name is derived from Palathu Chettiyar families, the prominent settlers of the region. A third school maintains that the first group of Christian settlers who came from 'Palayoor' (near Thrissur) was instrumental in christening the place.
Early settlements in the region date back to 1000 A.D. Palai is a trading centre of agricultural produces like rubber and pepper. The place had trade links with Tamil Nadu, Armenia and the Middle East. Palai is also used as a generic brand to the black pepper, coconuts and tamarind originating from the region.
The town is en-route the tourist resort at Vagamon. It is also an important halt for pilgrims proceeding towards the Hindu pilgrim centre Sabarimala.
The Catholic shrine of the blessed Sister Alphonsa is at Bharananganam, 5 km from Palai.