Thanks. glib looks like the culprit.
When filenotify used to work, I had glib 2.40.00 installed on RHEL 5.10.
Then I upgraded to glib 2.44.00 last week (also rebuilt emacs after that) in efforts to fix a frame issue I am still facing (
http://emacs.stackexchange.com/q/10745/115 ). The upgrade didn't fix that issue and it seemed that it didn't break anything so I stayed at that version.
But looks that that broke the gfilenotify functionality.
Now, I did make uninstall on glib 2.44.00 and reinstalled glib 2.40.00 and rebuilt latest emacs from master. But that did not fix the gfilenotify issue. I don't know what else I can look into.
Thanks for the help!