City have snapped up midfielder Palmer after he spent the second half of last season on loan with the Championship side, scoring twice in 17 games as they finished eighth in the table - four points outside of the play-offs.
Palmer joined Chelsea from the Charlton youth academy six years ago and was subsequently sent out on loan to Huddersfield Town, Derby County and Blackburn Rovers before his short spell at Ashton Gate.
As revealed by Goal on Wednesday, the England Under-21 international has opted to leave Stamford Bridge on a permanent basis, however, having snubbed interest from Swansea City to return to Bristol.
As well as being Bristol City's eighth signing of the summer, Palmer follows Tomas Kalas and Jay Dasilva's lead to become the third player to join the Championship side from Chelsea this summer.
Palmer has signed a four-year contract with the club just a few days before their Championship campaign kicks off with a game against Leeds United on August 4.
"I’ve been really impressed with his application and focus over the off-season period," Lee Johnson told the club's official website after the move was confirmed.
“Kasey has made big sacrifices to come here and we truly believe Bristol City and Kasey will be a fantastic match moving forward.”
And the club's chief executive, Mark Ashton, added: "We’re delighted to have Kasey here on a permanent contract and we again appreciate the assistance of Chelsea in coming to this agreement."
Palmer featured for Chelsea in pre-season under Frank Lampard alongside many others who returned from loan spells this summer, but the new coach permitted the sale of several prospects who do not fit into his plans for the 2019-20 campaign.
Palmer is one of two players to leave Chelsea on Thursday, as the Blues also sent Sterling out on loan to Wigan. The 19-year-old spent last season in English football's third tier helping Coventry City to an eighth-place finish but will spend 2019-20 in the Championship.
With the transfer window for Premier League and Championship sides closing on August 8, Chelsea still have to decide the futures of several other players.
The likes of Kenneth Omeruo, Baba Rahman, Jamal Blackman, Izzy Brown, Michael Hector, FIkayo Tomori and Trevoh Chalobah could all move on before the deadline
Chalobah is currently negotiating a permanent move to Huddersfield , Omeruo is still in talks with Celta Vigo and Leganes , while Rahman is expected to leave as well.
Tomori, meanwhile, is expected to leave on loan again after spending last term with Lampard in the Championship, but he is still part of the club's pre-season preparations.