Learn Russian: Эта иллюзия только кажется истиной.

The verb казаться (to seem) requires the noun or adjective that describes what the subject seems like to be in the instrumental case. Here, the feminine noun истина (truth) changes its -а ending to -ой to become истиной.

Could I use правдой (from правда) here instead of истиной?

You could, but they have slightly different meanings. Правда is the everyday word for truth, like the opposite of a lie. Истина refers to a deeper, more philosophical or absolute truth. When contrasting with an illusion (иллюзия), истина is the perfect fit because it refers to fundamental reality.

Is кажется a reflexive verb? How does it conjugate here?

Yes, казаться (to seem) is a reflexive verb, indicated by the -ся ending. It does not literally mean doing an action to oneself, but the particle is a permanent part of the word. Since the subject иллюзия is feminine singular (she/it), the verb takes the 3rd-person singular present ending -ет, followed by the reflexive particle -ся, giving us кажется.

Why is только placed before the verb?