According to the newspaper clippings, which are occasionally shown in the East Hall of the restaurant, a man dressed up as one of the restaurant's mascots, and then lured five children into the backroom of the restaurant. There, the perpetrator presumably murdered them, then proceeded to stuff their bodies into the animatronics. The police later arrested the culprit, but the bodies of the children were never found.
After this incident, many people began to complain of smelling an odor that was emitting from the animatronics, and they also said that the animatronics were leaking blood and mucus around their eyes and mouths. This, alongside the aformentioned murders, may have led to the restaurant's decrease in popularity, and eventual closing. It is theorized that Freddy and his friends are actually possessed by the ghosts of the slain children, (including Golden Freddy).
We are shown in Five Nights at Freddy's 3 that the spirits of the murdered children got their revenge. Some time after the events of the first game, the animatronics all tried to stop the purple man on their own, but failed miserably resulting in the destruction of the suits. After each of the characters were destroyed, the spirit of the crying child (the first victim of the Purple Man in Fazbear Entertainment's long history) shows up to take care of the killer once and for all. While the spirits of the children that inhabited the now destroyed animatronics watched the door, the crying child scared the Purple man into the Spring Bonnie (Springtrap's previous name) suit. As he hid, he mistakenly triggers the springlock mechanism, forcing the recoiled endoskeletal parts back into position, thus crushing the purple man until he bled out.