Paoli was laid out and platted in 1816. It was named for Pasquale Paoli Ash, the son of North Carolina governor Samuel Ashe. A post office has been in operation at Paoli since 1817.

In its first decades, it was noted as a Quaker town that played a role in the Underground Railroad by transporting enslaved people from the South to Canada. In the 1900s it became known as the site of the Pioneer Mothers Memorial Forest, a surviving fragment of the once-extensive virgin oak forest of southern Indiana.