Some background before questions:
I am an Indian citizen - no GC. I returned back to my home country in Jan 2010. I did not roll my 401k into IRA. I left it with my previous employer.. and the only employer I had 401k with. I was on H1B visa when I started my contribution.
Now, I never returned to work since Sep 2009. No taxable income in India or in US. When I left I did not file any forms to indicate I am leaving the country and will be a foreigner for US.For bank purposes(bank said they would close the account if it had a non-US address), I have an US address listed for that.- the main reason I did not file any forms.
Once I returned to India in Jan 2011, I filed tax for that year( using 1040) before due date of Apr 2010.-same as I did the previous years. I had taxable income in US for 2010 . In Dec 2010, I moved to a different country. I do not work here either. Now , I am thinking about withdrawing my 401k. I have about 28K in there.

Questions

If I file for W-8ben form I was told ( from Fidelity ) I would get all of my 401k funds back.- i.e no 20% and 10% penalty as per treaty with India. This seems too good to be true. Will be hunted down for paying taxes next year.
Given that I have what I have.. what is the tax approximately that I might pay in case I am required to pay anything the following year
will withdrawing in batches help my case?
I would like to keep all the funds I get from my 401k in US banks. I dont intend to take it out of the country. Will this coz a problem i cannot foresee?
I believe I might need to file 1040NR if I withdraw the 401k. What portions should I fill?
Please also highlight any problems that you foresee that might hit me.

Additional information, I am not yet anywhere close to 59.5yrs- will not be for a good 40+ yrs. I don't see me getting back into the country.. lets say for numbers sake at least another 10-25 yrs... though I believe in 'never say never'. For 40+ yrs, I believe the funds would do better for me in my pocket than in Uncle sam's.

Again I thank you for taking the time to read this long post. I am hoping someone can answer this

No, Fidelity is wrong. You will be subject to taxes and penalty. And in any case, Fidelity will withhold 20% (but not the 10% penalty) when you withdraw.

Depending on how much income you expect to earn in India, it could be advantageous in terms of US taxes to stretch the withdrawal in batches. However, note that you will be subject to Indian taxes on earnings in the 401k account/IRA when you become a resident of India again.

I just reread your message and it says that you are not staying in India now. In that case, you would not be subject to Indian taxes on earning in 401k/IRA. You may be subject to taxes in whichever country you live in now depending on your 'residency' status there.

But as far as US taxes are concerned, if you rollover 401k To IRA and withdraw small amounts each year up to the limit of exemptions and deductions allowed under 1040NR, you should not have to pay any tax. But the 10% penalty will still be levied.

You could rollover 401K to IRA, then convert to Roth IRA either gradually or at once (you will pay taxes on the conversion, but no penalty). Then after 5 years, you can withdraw this money tax free in the US. But like I said, you have to consider taxes on earnings in the place you are a resident too