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Thats a ton of information which is very much simplified.. Specially the graphics ;)
Anytime.
I have a clear understanding now.. So what i figured is as far as my ISP goes, he only knows that i am using Tor, period.
Anyone who can monitor both ends of the connection can tell who is doing what by looking at who sends data into Tor and when similarly sized data leaves Tor. There are other attacks as well. Generally speaking though, I think its safe to assume that your ISP will only be able to see that you are using Tor.
Rest all is good to go.. All thanks to encryption. Then i assume this makes it a better option than VPN. Am i right?
Generally speaking Tor does a better job anonymising you than a VPN does. To use the previous metaphor, in a VPN you take your message to Google and you put it in an envelope to Alice. Alice then sends it to Google for you. Alice knows who you are and who you are talking to. Google just knows you send things via Alice. Your ISP knows that you use Alice as well. Alice is the weak point here as if she caves or is untrustworthy, you have no protection.
Using a VPN just shifts who can watch you from your ISP to your VPN provider. This is a good thing if you trust your VPN provider more than your ISP, but someone still knows who you are and what you are doing.
Also a quick question jumped in.. Say i have a Raspberry PI which is converted to a TOR router and i connect my machine to this router. Will this make the entire traffic go via TOR including something as simple as a ping request.
No. There is some additional configuration that needs done. If you'd like all of your traffic to go through Tor, I'd recommend using Tails. https://tails.boum.org/
Say i ping a machine on the web, will it stay anonymous or i will have to use proxychains, for what i know both of them are doing the same thing apart from encryption in TOR as an added feature.
I'm not very familiar with proxychains, so I can't answer that.
Also this seems like a conversation best brought to the Tor-talk mailing list rather than the Tor-relay list. At least the general Tor questions part of it.
Thank you, Derric Atzrott