Everybody knows everybody. None of your examples are correct.

I'm from the mid-western United States, and we use both #1 and #3, but would probably use #1 most of the time. In this context, we probably would use the word "everybody" to indicate "all people". I would very seldom use "all people" in a sentence like this, and would just use "everybody". "In a small town everybody knows each other and everybody's business." This would indicate that since towns are small and there are few people, that everybody is acquainted with each other and knows what each person is doing in their life.

Correct : 3)In a small town all people know each other. Another Version : In a small town, people often know each other. :)

I would agree with psmithphil. #1 would be used most frequently. Although #3 is technically correct, "all people" isn't a word combination that is often used. Also, I'm from the south. =)

in a small town all people know each other