The area now known as Penola was first squatted on before 1840 by Solomon, Josiah and Thomas Austin at Yallum. The first settlers were Scottish born Alexander Cameron and his wife Margaret, nee MacKillop, in January 1844 after obtaining an occupation licence. In April 1850 Cameron obtained eighty acres of freehold land, his station was on a pastoral lease, and established the private town of Panoola, later known as Penola. He set aside several blocks for the use of the community, including a market square and blocks for churches to be built on at a later stage.

Although a long way from Adelaide, Penola soon had most of the facilities available in any big town at that time. Its first residents were Christopher Sharam, a bootmaker and his wife Ellen. They were to have fifteen children. One of the first shopkeepers was Andrew McAlpine who opened his 'South Australian Store' in the early 1850s. A post office was constructed in 1857.
In the early days religious services were held in the local courtroom. The Presbyterians were the first to make use of this facility. The Reverend Mark Dixon was the first to reside in Penola and stayed from 1856 until 1864. He was replaced by the Rev James Don. The Catholics started with the building of their wooden church in 1858 when Father Julian Tenison Woods laid the foundation stone of Saint Joseph's Church. Their first resident priest was Father Powell who also had established a school in 1855. A new stone church was completed in 1865 at a cost of one thousand Pounds. Most of this money had come from well to do Highland Scots. The Church of England's Saint Mary's was completed in 1873.

By the 1860s Rounsevell coaches left Penola twice a week for Naracoorte, Mount Gambier and Adelaide and Cobb and Co coaches three times a week for Melbourne. It had a population of over 600 people who were served by a local court, police station, two churches, an Institute, telegraph, school and several resident magistrates among them, J.M. Carter, E. Kirby, G. Riddoch, G.B. Scott, J.A. Wells and H.E. Wells. Penola also boasted the second largest library outside Adelaide as early as 1863. The Government town of Penola North was surveyed in 1867 but renamed Penola on 20 February 1941.

Penola has been home to some very famous and interesting people. Among them Mary MacKillop, John Shaw Neilson, Father J.T. Woods, Adam Lindsay Gordon, William Henry Ogilvie and John Riddoch.

It was Riddoch who planted the first grape vines and helped to diversify the pastoral economy of the area with an agricultural industry. In 1878 he built the Yallum homestead. It was completed in 1880. In 1890 he established the Penola Fruit Growing Colony which was renamed Coonawarra in 1897. Being a highly regarded personality, Riddoch was asked several times to lay foundation stones or to open new buildings or institutions.