Yes, refunds for a current tax year are always based on not owing for a prior year. If you owe or the IRS believes you owe, they will diminish the refund by that amount. If you do nothing to resolve it, they will keep the amount as payment of debt.
A word to the wise, never take the IRS' word that you owe taxes. Check the facts yourself.
If you disagree, send a letter explaining why. Include any supporting documentation that you might have. This goes for penalties and interest too. Even if you do owe, you can often get a reduction in penalties and interest by explaining the circumstances, promising to do better, and requesting relief. The worst they can do is say, "no."
You should always ask and you should always follow phone converstations with a letter. Be sure to get the name and ID number of any IRS employee that gives you advice. If you don't have this information and the advice was incorrect, you may be liable for penalties and interest for the error.
Yes. They will withhold the amount due as insurance. Once the past bill is paid, they'll release it.