I lived in Texas and worked for a company that had a 401k program. While I lived their I saved over $40,000 in my 401k. In 1996 I moved to Georgia and became a resident of that state. From 1996 to 2001 my 401k value dropped to $33000. In 2001 I cashed it in. I was charged a penalty and taxes were taken out. I ended up with $23000. At the end of the year I had to pay more taxes. I expected all of this. Now in 2007 I have received an assessment from the state of Georgia saying I owe $3200 in state taxes for money I made in Texas while a Texas resident. Is this a mistake or can they really do this?

I lived in Texas and worked for a company that had a 401k program. While I lived their I saved over $40,000 in my 401k. In 1996 I moved to Georgia and became a resident of that state. From 1996 to 2001 my 401k value dropped to $33000. In 2001 I cashed it in. I was charged a penalty and taxes were taken out. I ended up with $23000. At the end of the year I had to pay more taxes. I expected all of this. Now in 2007 I have received an assessment from the state of Georgia saying I owe $3200 in state taxes for money I made in Texas while a Texas resident. Is this a mistake or can they really do this?
You cashed in the 401(k) in 2001 while a GA resident, so that's when (and where) you received the income. The fact that there were paper gains and losses prior to 2001 is immaterial. So I'd say yes, you should have paid income taxes to GA for the distribution in 2001.