Unfortunately there are only a few good sources from where we can get accurate and trustworthy information about the ancient period. Generally there is a lot of speculation and very little proof, which makes the historians job very difficult. However, we do know that human migration, such as the Aryans and later the Moghuls have played a major role in instrument design and style. Other sources are the Indian miniatures and temple sculptures.
The earliest period that is of significance is the Indus valley civilization, which existed from 3000 to 2000 BC. We can see from the statues of dancers that music was a developed art form. Unfortunately there is almost no further information available, maybe due to the fact that the Aryans destroyed a lot of the cities and probably the documented information also.
The Vedas are one of the early sources of information and many instruments are mentioned: flutes, harps, trumpets and drums. The Vedas were among some of the major sources of information available to Bharata, 1500 years ago, when he wrote probably the most famous of historical books on Indian musical instruments, the Natyashastra. The Natyashastra was the first major work on music and theatre. Bharata was the first to put down musical ideas on paper, thereby laying down the tradition. About the same period, Dattilam wrote a short but powerful scientific book about the "old music".
Through the beautiful and informative sculptures of the early Indian temples and stupas, we can get a clear picture of the instruments used. From the second century BC we can see two stringed lutes, harps, drums and dancers, which were played in the temples and palaces of old India. Around this time the greatest Indian musicians were invited by the Persian Sasanian kings to teach Indian music to the Persian musicians.
From the 8th century AD the Islamic empire started to introduce the highly evolved culture into India. The Muslims were very tolerant of the existing Indian music, and the sultans enjoyed surrounding themselves with hundreds of musicians and dancers. Slowly, over the next couple of centuries, the Islamic music had taken root in the Indian musical traditions.
The Muslims did not reach Southern India, therefore the change did not affect the music there, and they were not interested in the new foreign instruments. This created the main difference in musical styles between the Northern Hindusthani and the Southern Carnatic styles of Indian music.