Custom sprites are just altered or totally replaced sprites over existing ones. They were a means to cater for further personalization throughout ones' PMU journey.
Here's an article that dives deeper into this topic Using custom sprites instead of regular ones
In regards to why this happened is a tricky situation to grasp in its entirety, but mainly there were two main points. One was to improve the protection of spriters' works. The other was due to transitioning to a new encoding in preparation for the release of shinies.
The PMU Toolkit was the software many spriters used then. As of now, or still known means, most spriters rely on the devs to encode and compile their works.
Here's a hyperlink to the PMU Toolkit (outdated, but work for some stuff)
At the moment, the PMU team has acknowledged the community's interest in custom sprites. However, with the lacking manpower and juggling IRL for the team, it will be some time before a means for custom sprites to become reality again comes to fruition. As the community all we can do at the moment is petition through the forums along with just keeping on creating and expressing your works.
There is currently the forum post kickstarting this momentum again Custom Sprites and the State of the PMU Toolkit 2024