I still use Palace Chat!
My theory for the reason why the population got so small is: everyone who designed palaces/ made avatars/ scripted/ etc. grew up, started families, and lost interest in Palace as a whole, and so Palaces started shutting down. As a result, there is nowhere for anyone to go, and so everyone else left as well. And now when new people come on, all they see are dead palaces, and don't stick around. I learned how to make avatars/ backgrounds/ script/ etc. because there were plenty of tutorials around and people to teach me. There's nothing like that anymore, so people who DO want to open up their own palace don't know how.
Long story short: if you want Palace to become active again, the first step is to start going on and staying on. The second step is to convince your friends to play. The third step is to bring back the creative community that was once the backbone of Palace. I'm thinking of starting up a website with Palace resources so that new members have a starting point to work from.
If anyone wants to hang out on Palace, you can find me on AvatarPalace. My name is "mina."