Folsom is named for Joseph Libbey Folsom who purchased Rancho Rio de los Americanos from the heirs of a San Francisco merchant William Alexander Leidesdorff, and laid out the town called Granite City, mostly occupied by gold miners seeking fortune in the Sierra Nevada foothills. Though few amassed a great deal of wealth, the city prospered due to Joseph Folsom's lobbying to get a railway to connect the town with Sacramento. Joseph died in 1855, and Granite City was later renamed to Folsom in his honor. The railway was abandoned in the 1980s but opened up as the terminus of the Gold Line of Sacramento Regional Transit District's light rail service in 2005. A few former gold-rush era towns are located within city limits of Folsom, including Prairie City, Salmon Falls, and Mormon Island (though these towns no longer exist).

Folsom hosted a significant Chinese-American community when it was first incorporated, but arsonists burned Folsom's Chinatown in March 1886, driving Chinese-Americans out of town.

The establishment of Folsom Prison came in 1880, when the Livermore family made an agreement with the state to donate land for the prison in exchange for prison labor. They planned to build a hydro-electric dam from the American River for a sawmill. Though the sawmill did not work out, the Livermores soon realized that the natural force of running water could provide enough power to transmit to Sacramento, and the Folsom Powerhouse, now a National Historic Landmark, was opened. At the time it was opened, it had the longest overhead run of electricity (22 miles) in the country. The powerhouse operated until 1952.

Folsom Dam was built in 1956, providing much-needed flood control and water rights for the Sacramento Valley. The creation of this dam also created one of the most popular lakes in Northern California, Folsom Lake. The dam is located on the southwest corner of the lake. The lake is an estimated 4.8 miles from Granite Bay to the most southern point of Folsom Lake. Like most lakes in California, Folsom Lake is way below capacity.