It's the city.
In the preceeding sentence city is clearly the subject and the other nouns mentioned (side, mountain, part, pile) are only there to describe aspects of the city.
It follows that, in the beginning of the next sentence, it must refer to the city:
The fire had gone out of it [the city]
Grammatically, fire is the subject of that clause. However, in terms of what O'Connor is talking about, her main focus is still the city.
The second part of the sentence reads and it appeared settled into its unbreakable parts.
Here it can only refer back to the it which immediately preceeds it:
The fire had gone out of it and it appeared settled into its
A good writer will refocus the reader's attention if she wants to change from talking about the city to something else. She cannot have it refer to the city AND the fire in the same sentence without restructuring the whole thing.
If she wanted to switch focus to the fire, the simplest thing would be to omit the second it:
The fire had gone out of it and appeared settled into its
Replies to Peyman's comments:
- It is not a null subject here. I think you are mistaking the original phrase for a neutral part of speech such as It was a sunny day. Your example introduces a new noun (book). I'll substitute 'boy' for 'book' to avoid too many confusing its.
It seemed/appeared the boy was right or It seemed/appeared he was right.
Who seemed to be right?
Answer: The boy.
In the original sentence there is no 2nd noun/pronoun, only the verb 'settled'.
Who or what appears settled?
Answer: It does.
Comments 2 & 3:
Your restructured sentence could be interpreted the way you have suggested, but that is not what O'Connor wrote. You have removed it appeared, based on your 'open book' example, but there is no 'open book' equivalent in O'Connor's sentence. The thing that appears settled is it, and I maintain this is the city for the reasons given above.