The Dominion was the result of spirits growing immensely wise and powerful within the First Faloran Empire. Some spirits became so powerful that they became Archons - living symbols at the heart of entire cultures and belief systems throughout the Empire. While some Archons arose as the result of the Empire, others had merely been absorbed into it.
Nonetheless, it was the Archon who sat at the right hand of the Emperor, Radiance, who ultimately undid both the Last Emperor of the Palaienid, and his Empire. The Last Emperor saw that the power of mankind had been challenged by spirits, and that his own office was becoming meaningless as a result. Thus, he led an attack on the holy Cariapolis of Falor in anticipation of the Eclipse, in an attempt to kill Radiance. His timing, however, was poor, and he arrived too early - and was killed. This led to the end of the Empire, and caused Radiance to declare the reign of spirits as begun - transforming Empire into spirit Dominion.
This led to Malvern declaring independence, and for unrest to remain in the former Empire until the Arbiter arose to declare Common Law and establish harmony between man and spirit - and between neighbours and Archons.