There's been a palace at this spot for many centuries, but the oldest part of this current building is from the mid-16th century. Succeeding rulers added turrets, new wings, and new decorating styles at whim, so it's an architectural hodgepodge. The royal family moved out over 100 years ago to a hideous complex in the newer part of town, but this palace is stil used for important ceremonies. Only one of its ten courtyards is open to tourists, pictured above.
The impressive size of the palace gives a misleading sense of the royal family's historical importance. Since the 1400's the Kathmandu Valley was divided among the king's three sons to form three competing kingdoms, Kathmandu, Patan and Baktapur (both of which you'll see later). These really all merge into one city now, to give you a sense of how tiny their "empire" really was. The rest of Nepal was divided among 45 different royal families, mostly refugee nobles from India. Three centuries later one of these tiny kingdoms managed to invade all three of the Kathmandu Valley kingdoms and establish a real Nepal for the first time, then gradually add the dozens of other tiny kingdoms outside the Valley.
Civil war among the family members immediately broke out following unification, which continued until the Ranas, a prominent military clan essentially overthrew the royal family around 1850. Then, a la Japan, they ruled as shoguns and relegated the royal family to a purely ceremonial role. The Ranas were overthrown after the second world war, but there's a secret agreement between the Ranas and the royal family to continue sharing power. The two families intermarry constantly (the queen killed by the Crown Prince was a Rana) and the Ranas continue to dominate the military and most cabinet posts. In short, it's a total mess of a political system, but it looks like all this history may not matter much as the Maoist guerillas are determined to get rid of both families, and the current much despised king is making the job easier.
