Electronic – arduino – Using optocoupler with MOSFET for dimming a LED

First of all, "saturation" in mosfets means that change in VDS will not produce significant change in the Id (drain current). You can think about MOSFET in saturation as a current source. That is regardless of the voltage across VDS (with limits of course) the current through the device will be (almost) constant.

Now going back to the question:

According to wikipedia, the MOSFET is in saturation when V(GS) > V(TH) and V(DS) > V(GS) - V(TH).

That is correct.

If I slowly increase the gate voltage starting from 0, the MOSFET remains off. The LED starts conducting a small amount of current when the gate voltage is around 2.5V or so.

You increased The Vgs above Vth of the NMOS so the channel was formed and device started to conduct.

The brightness stops increasing when the gate voltage reaches around 4V. There is no change in the brightness of the LED when the gate voltage is greater then 4V. Even if I increase the voltage rapidly from 4 to 12, the brightness of the LED remains unchanged.

You increased the Vgs making the device conducting more current. At Vgs = 4V the thing that is limiting amount of current is no longer transistor but resistor that you have in series with transistor.

I also monitor the Drain to Source voltage while I'm increasing the gate voltage. The drain to source voltage drops from 12V to close to 0V when the gate voltage is 4V or so. This is easy to understand: since R1 and R(DS) form a voltage divider and R1 is much larger than R(DS), most of the voltage is dropped on R1. In my measurements, around 10V is being dropped on R1 and the rest on the red LED (2V).

Everything looks in order here.

However, since V(DS) is now approximately 0, the condition V(DS) > V(GS) - V(TH) is not satisfied, is the MOSFET not in saturation?

No it is not. It is in linear or triode region. It behaves as resistor in that region. That is increasing Vds will increase Id.

If this is the case, how would one design a circuit in which the MOSFET is in saturation?

You already have. You just to need take care for operating point (make sure that conditions that you have mention are met).

A) In linear region you can observe following: -> when increasing the SUPPLY voltage, the LED will get brighter as the current across resistor and transistor will rise and thus more will be flowing through the LED.

B) In saturation region something different will happen -> when increasing SUPPLY voltage, the LED brightness will not change. The extra voltage that you apply on the SUPPLY will not translate to bigger current. Instead it will be across MOSFET, so the DRAIN volage will rise together with supply voltage (so increase supply by 2V will mean increasing drain volage by almost 2V)

The RED LED should not be glowing. Maybe something is wired wrong or the 2N7000 is damaged, but there should not be more than nA of current flowing with 10mV on the gate, which will not produce a visible amount of light in normal room lighting, even with the most efficient red LED. Try replacing Q2 after checking the wiring.

Of course if you are leaving some types of multimeter connected where you are measuring the 0.35V then there could be enough current through the meter to provide a faint light from the LED.

There is no problem in reverse biasing LEDs up to the rated voltage (usually 5V), and in fact far beyond that typically (but there are no guarantees so you shouldn't do that).