Before the 205, Peugeot was considered the most conservative of France's big three car manufacturers, producing large saloons such as the 504 and 505, although it had entered the modern supermini market in 1973 with the Peugeot 104. The genesis of the 205 lay within Peugeot's takeover in 1978 of Chrysler's European divisions Simca and the former Rootes Group, which had the necessary expertise in making small cars including the Simca 1100 in France and Hillman Imp in Britain. It was around this time that Peugeot began to work on the development of a new supermini for the 1980s.

The 205 was launched in right-hand drive form for the UK market in September 1983. It was one of five important small cars to be launched onto the European market within a year of each other: the other four were the Fiat Uno, the second generation Ford Fiesta, the original Opel Corsa/Vauxhall Nova and the original Nissan Micra. Its launch also closely followed that of the Austin Metro and Volkswagen Polo Mk2.

The 205 was an instant hit, and its styling was echoed in many Peugeot models that were to follow, as well as markedly changing the company's perception with buyers. Such was the success of the 205 that, apart from details, its exterior styling was never facelifted or significantly altered in its 15-year production run. At the beginning of 1993, Peugeot launched the 306, which officially replaced the 309; the arrival of this car also diminished the 205's role (and its sales figures) in the Peugeot range, as had the arrival of the smaller 106 in September 1991 – although the final demise of the 205 was still some years away.

The 205 was first available as a GTI in 1984 (the same year that the three-door bodystyle debuted) and was initially powered by a fuel injected 1.6 petrol engine. The 1.9 GTI was launched in 1986 and the 1.9-litre engine was also used in the GTI version of the larger 309. The 205 GTI was discontinued in 1994, by which time Peugeot was producing high performance versions of the 106 and 306.

After several years of gradually declining sales, the Peugeot 205 was discontinued in the United Kingdom in 1996. 5,278,050 Peugeot 205s have been sold, and a significant percentage of them were still in circulation as of 2009. By 2014, there were still as many as 14,000 on the road in the United Kingdom, compared to the peak high of 374,773 in 1994. With potentially as many 400,000 sales in the UK, it became the best selling car ever sold by Peugeot in the UK.