Just wanted to add that folder permissions up the directory tree need to be set a certain way.

sshd's strict ownership/permissions requirements dictate that every directory in the chroot path must be owned by root and only writable by the owner.

Source

I was having a very similar error, and fixing my directory permissions fixed the issue for me.

I'm using Ubuntu LTS 12.04 and after a lot of pain, this worked for me.

My Settings for /etc/ssh/sshd_config

Subsystem sftp internal-sftp -f AUTH -l VERBOSE
UsePAM yes
Match group sftp
  ChrootDirectory %h
  ForceCommand internal-sftp
  AllowTcpForwarding no

1. create group sftp:

   groupadd sftp

2. Create user directly with new sftp group attached:

   sudo useradd -d /ftpusers/HomeFolder -m UserName -g sftp -s /bin/false

3. set permissions for use with ssh for sftp:

   chown root:root HomeFolder

   chmod 755 HomeFolder

4. restart service:

   service ssh restart

Note, the home folder for the new sftp user has to be given root owner.

Here is a step by step guide to allow:

1. SFTP access to /home/bob/uploads for user bob
2. Lock bob out of SSH
3. Use username/passwords rather than keys:

First, edit your /etc/ssh/sshd_config file:

sudo nano /etc/ssh/sshd

Scroll down and modify:

PasswordAuthentication yes

and add this at the bottom:

Match Group sftpusers
ChrootDirectory %h
ForceCommand internal-sftp
AllowTcpForwarding no  

Press Ctrl-X to exit and save.

Now add the user:

sudo useradd bob
sudo passwd bob

Now add the groups and disable ssh:

sudo groupadd sftpusers
sudo usermod  -g sftpusers bob
sudo usermod -s /usr/bin/rssh bob
sudo usermod -d /home/bob bob

Now set permissions:

sudo chown root:root /home/bob/
sudo chmod 755 /home/bob/
sudo mkdir /home/bob/uploads
sudo chown bob /home/bob/uploads

sudo service sshd restart

All this is while logged in as a root user (ec2-user on Amazon Linux AMIs)

Also note when adding the Match directive to the config file, that any directives not relevant to what you are matching may stop working. Rather than commenting everything out which is not compatible, simply move any sections which includes a Match directive to the end of the config file.

Furthermore, permissions probably need to be set to 755 on the chroot directory and any parent directories, and the owner to root:root. Personally, I set up the chroot directory sshd_config to be %h, the user's home directory, and then set their home directory to where I want it to be, such as /var/www/examplewebsite.com. Some may prefer to configure a chroot home directory with a static portion followed by the username, such as /var/www/%u, however this requires ensuring your user's chroot dir matches its username, of course.

To troubleshoot connection issues, stop the ssh service, being sure to open an SSH session or two first for testing, and then start the daemon interactively in debug mode to examine the connection debug info, as this may help you identify any problems, and search up how to fix them.

Commands: service ssh stop ; /usr/sbin/sshd -d

Be sure to start ssh up again after you're done! Command: service ssh start