If the sludge problem has gone on long enough, and is severe enough, then yes, this could eventually lead to cylinder/piston damage. This is due to low oil pressure caused by sludge deposits in the screen of the oil pump pickup tube. Usually, however, there are initial warnings, such as an oil pressure or "STOP ENGINE" light. At this point, a sludge repair job will not restore lost compression, as the damage is already done.
However, it's really best to get a second opinion by someone very familiar with late-model Volkswagens. I can only offer advice by the information given to me. I could be a lot more specific if I were able to lay my hands on it, so to speak. Definitely worth researching your area for a good independent European/VW shop.
Usually when I get A4s and Passats with 1.8T's in with sludge problems, I can typically correct the problem before it gets too far. Normally, the first sign is a mechanical rattle at idle when the engine coolant and oil are both at operating temperature. The noise comes from the timing chain tensioner at the rear of the cylinder head. This tensioner is actuated by oil pressure, and is the furthest component from the oil pump, so it's the first part to "complain". However, once we get to compression loss, there is significant cylinder/piston ring damage, and de-sludging will not bring this back.
Still, if the car were in my shop, I would definitely pull all spark plugs and run a borescope into the cylinders to be absolutely sure.