I have chrooted sftp setup as below.

# Package generated configuration file
# See the sshd_config(5) manpage for details

# What ports, IPs and protocols we listen for
Port 22
# Use these options to restrict which interfaces/protocols sshd will bind to
#ListenAddress ::
#ListenAddress 0.0.0.0
Protocol 2
# HostKeys for protocol version 2
HostKey /etc/ssh/ssh_host_rsa_key
HostKey /etc/ssh/ssh_host_dsa_key
#Privilege Separation is turned on for security
UsePrivilegeSeparation yes

# Lifetime and size of ephemeral version 1 server key
KeyRegenerationInterval 3600
ServerKeyBits 768

# Logging
SyslogFacility AUTH
LogLevel INFO

# Authentication:
LoginGraceTime 120
PermitRootLogin without-password
StrictModes yes
AllowGroups admins clients

RSAAuthentication yes
PubkeyAuthentication yes
#AuthorizedKeysFile %h/.ssh/authorized_keys

# Don't read the user's ~/.rhosts and ~/.shosts files
IgnoreRhosts yes
# For this to work you will also need host keys in /etc/ssh_known_hosts
RhostsRSAAuthentication no
# similar for protocol version 2
HostbasedAuthentication no
# Uncomment if you don't trust ~/.ssh/known_hosts for RhostsRSAAuthentication
#IgnoreUserKnownHosts yes

# To enable empty passwords, change to yes (NOT RECOMMENDED)
PermitEmptyPasswords no

# Change to yes to enable challenge-response passwords (beware issues with
# some PAM modules and threads)
ChallengeResponseAuthentication no

# Change to no to disable tunnelled clear text passwords
#PasswordAuthentication yes

# Kerberos options
#KerberosAuthentication no
#KerberosGetAFSToken no
#KerberosOrLocalPasswd yes
#KerberosTicketCleanup yes

# GSSAPI options
#GSSAPIAuthentication no
#GSSAPICleanupCredentials yes

X11Forwarding yes
X11DisplayOffset 10
PrintMotd no
PrintLastLog yes
TCPKeepAlive yes
#UseLogin no

#MaxStartups 10:30:60
#Banner /etc/issue.net

# Allow client to pass locale environment variables
AcceptEnv LANG LC_*

#Subsystem sftp /usr/lib/openssh/sftp-server

# Set this to 'yes' to enable PAM authentication, account processing,
# and session processing. If this is enabled, PAM authentication will
# be allowed through the ChallengeResponseAuthentication and
# PasswordAuthentication.  Depending on your PAM configuration,
# PAM authentication via ChallengeResponseAuthentication may bypass
# the setting of "PermitRootLogin without-password".
# If you just want the PAM account and session checks to run without
# PAM authentication, then enable this but set PasswordAuthentication
# and ChallengeResponseAuthentication to 'no'.
UsePAM yes



Subsystem sftp internal-sftp

Match group clients
    ChrootDirectory /var/chroot-home
    X11Forwarding no
    AllowTcpForwarding no
    ForceCommand internal-sftp

a dummy user

root:~# tail -n1 /etc/passwd
david:x:1000:1001::/david:/bin/sh

Now in this case david can sftp using say filezilla client and he is chrooted to /var/chroot-home/david/. But what if i was to setup a passwordless auth? I have tried pasting his key in /var/chroot-home/david/.ssh/authorized_keys but no use, tried ssh'ing as david to the box and it just stops at "debug1: Sending env LC_CTYPE = C" after i supply it password and there is nothing shown in auth.log, may be because it can't find the homedir. If i do "su - david" as root i see "No directory, logging in with HOME=/" which makes sense. Symlink doesn't help either.

I have also tried with:

Match group clients
        ChrootDirectory /var/chroot-home/%u
        X11Forwarding no
        AllowTcpForwarding no
        ForceCommand internal-sftp

a dummy user

root:~# tail -n1 /etc/passwd
david:x:1000:1001::/var/chroot-home/david:/bin/sh

This way if i don't change /var/chroot-home/david to root:root sshd complains about bad ownership or permission modes, and if i do, david can no longer upload/delete anything directly in his home while using sftp from filezilla.