Hovering precariously above the drop zone coming into the game, the victory gives Tony Pulis' side a massive lift in their bid to avoid relegation straight back to the Championship as they now sit 16th, five points clear of the bottom three.
After Chelsea's resounding 6-0 win over Arsenal last week, and Palace's last-minute defeat at Newcastle United, many expected a routine three points for Jose Mourinho's table-toppers, but the hosts upset the form book by recording their first league win over their London neighbours since 1990.
Pulis' team came up against a Chelsea outfit that had been rampant in thumping Arsenal, but there was no sign of that ruthless attacking vigour at Selhurst Park as the home side nullified their opponents.
Mourinho was gushing in his praise of the Palace fans after the reverse fixture in December, and they were in fine voice once again on Saturday, particularly when Terry put through his own net in the 52nd minute.
Joel Ward whipped in a cross from the left-hand side, and as the Chelsea skipper challenged Joe Ledley, the ball glanced off his head and flew past Petr Cech.
It was a huge setback for Mourinho's men, who missed out on the chance to go four points clear at the top with fellow title contenders Liverpool and Manchester City still to play this weekend.
After a quiet opening to the game, Andre Schurrle squandered the first genuine opening in the 18th minute, prodding the ball wide from four yards after stretching to reach Cesar Azpilicueta's low cross at the back post.
The hosts had a chance of their own eight minutes later, Yannick Bolasie struggling to control a fizzing Jason Puncheon delivery before poking his effort into the side netting.
Palace then had two penalty shouts waved away in as many minutes as first Cameron Jerome tumbled under a challenge from Nemanja Matic before Bolasie pleaded with referee Lee Mason following a sliding tackle from Gary Cahill.
Terry scored at the wrong end shortly after the interval, heading Ward's cross beyond Cech at the near post under pressure from Ledley.
Chelsea almost levelled immediately, Julian Speroni diving full length to his left to keep out Eden Hazard's curling effort from the edge of the area.
As the game became more open, Puncheon's left-foot shot went narrowly wide of the post in the 62nd minute, before Terry nodded Oscar's free-kick just over the crossbar 60 seconds later.
Speroni was the hero once again 17 minutes from time, producing an incredible close-range save from Hazard to deny the Belgian what looked a certain goal, before Palace broke straight down the other end, only for Jerome to strike the outside of the post.
Ledley twice went close for the hosts in the final stages, but it mattered little as Palace held on for a surprise win to send Selhurst Park into raptures.
