As far as I know protocol updates are made on main net about every 3 months. When this happens all balances, smart contracts, and smart contract state are preserved on main net. But how does it work on test net, is the existing state on the old protocol on test net abandoned and a new instance of a test net blockchain started?
Yes, the old testing networks are abandoned and brand new networks are launched using the new to-be-activated protocol.
For instance, Carthagenet will be deactivated on 12/12/2020. The current Delphinet test network will remain as a protocol copy of mainnet. Edonet was launched yesterday, which is using the upcoming beta 008 protocol.