The duo formed a week after Brian Viglione witnessed Amanda Palmer perform solo at a Halloween party in 2000. Their live performances soon gained them a cult following. During these performances the two band members often wear dramatic make-up and fancy clothing that push their cabaret/theater aesthetic. They encourage fans to become involved at their shows, with the fans' own stilt walking, living statues, fire breathers and other performance art becoming an integral part of the show. The Dirty Business Brigade coordinates the fans' performances.

The band's first name was Out of Arms. At some point, the name became The Dresden Dolls. The name, according to Palmer, was "inspired by a combination of things," including the firebombing of Dresden, Germany and the porcelain dolls that were a hallmark of pre-war Dresden industry; an early song of the same name by The Fall; and a reference to the V. C. Andrews novel Flowers in the Attic, where the classically blond-haired and blue-eyed protagonists are called "the Dresden dolls." The name also evokes Weimar Germany and its cabaret culture. Additionally, Palmer "liked the parallel between Dresden (destruction) and Dolls (innocence, delicacy), because it is very much in keeping with the dynamics of the music, which sometimes goes from a childlike whisper to a banshee scream within a few seconds."

The duo was featured in a webcast performance at the 2002 Ig Nobel Prize ceremony in Cambridge, Massachusetts. After a self-promoted demo recorded and released in 2001, their first release was the mostly live compilation A Is for Accident (Important Records), followed in 2003 by a self-titled debut produced and recorded by Martin Bisi (Swans, Sonic Youth) at The Old American Can Factory in Gowanus, Brooklyn. The album features fellow Boston-area musicians Ad Frank (guitar on "Good Day") and Shawn Setaro (bass on "Good Day," "Gravity" and "Jeep Song"). Two songs off the album ranked in the Triple J Hottest 100, 2004: "Girl Anachronism" at #30 and "Coin-Operated Boy" at #12. In 2003 they were crowned the winners of Boston's long-running WBCN Rock & Roll Rumble.

On October 6, 2005 The Dresden Dolls were interviewed by the subject of one of their songs, Christopher Lydon, on the radio show Open Source.

In March 2005, the duo supported Nine Inch Nails on tour. On June 5, 2005, The Dresden Dolls hosted a free concert at the Paradise Rock Club in Boston. When a power outage unexpectedly delayed their performance, city streets became a temporary stage for some of the many performers (living statues, stilt-walkers, and fire-breathers) who had come from across the world to entertain audiences. The entire event — concert and street performances — was filmed and the resulting DVD, Live: In Paradise, was released in Europe on Oct. 10, 2005 and in North America on November 22, 2005, shortly after the band's fall 2005 tour.

The Dresden Dolls' second studio album, Yes, Virginia..., was released on April 18, 2006. Over the summer of that year, the duo performed at South by Southwest, Bonnaroo, Britain's Reading and Leeds Festivals, and Lollapalooza, in addition to touring with Panic! at the Disco as their opening act. During the support tour, the band presented "Fuck the Back Row — A Night of Celluloid Vaudeville." The events consisted of screenings of short films from friends and fans, performances by local artists, and a solo show by Palmer who performed mostly cover songs inspired from film soundtracks.

In June 2006, The Dresden Dolls Companion was released by Amanda Palmer. The book contains a history of the band and their first album — The Dresden Dolls — as well as a partial autobiography. The book also contains the lyrics, sheet music, and notes on each song on the album, as well as a DVD featuring a 20-minute interview with Palmer about the origins of the band and the first LP. The interview was conducted by a friend while Palmer compiled the artwork for the first LP.

On August 16, 2006, the East Providence Community Theatre in East Providence, Rhode Island premiered a full-length, fan-written jukebox musical, The Clockwork Waltz, featuring songs from The Dresden Dolls' three albums. The show was encouraged by the band and their management.

In December 2006 and January 2007, the music of The Dresden Dolls was featured in an original production — The Onion Cellar — at the American Repertory Theatre's Zero Arrow Theatre in Cambridge, Massachusetts. The play is co-authored by Amanda Palmer, from her original concept.

On January 14, 2007, the duo took a temporary hiatus. Palmer worked on her solo album, Who Killed Amanda Palmer, while Brian Viglione toured with Boston-based HUMANWINE and other local Boston acts, along with touring with Jesse Malin and offering drum clinics.