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I'm on EC2 t2.small instance (2GB RAM) and keep getting locked outside the server without the ability to ssh into it.

the error message is ssh_exchange_identification: read: Connection reset by peer

Knowing the application, I assume it leaks memory and that SSHD is blocked due to that.

Is there a way to allow SSH connection to a Linux box that has its RAM full?

Can I someone have SSHD reserve enough memory for new connections?

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You cannot pre-allocate memory but you can set the memory limit so that sshd doesn't eat all the memory. use man ulimit to check the details. If a Java app, use -Xmx to set max amount of memory which can be used.