I got myself a new bike and i have been told by many to reduce the seat height or bend more to cycle such that the thighs touch your stomach or atleast closer to stomach as you cycle. They say it will reduce the flab quickly and better workout.
Is this true?
I think that this is a bad advice you've heard (by many?).
For pedaling seated, the seat has only one position; the proper one. See How do I determine the correct position for my bicycle seat? for info on how to set it correctly.
Regarding the flab thing, as far as I know touching your stomach with your thighs (or any other part of your body) will not contribute to a better workout or a six pack. For that I guess you'll need lots of proper training and a consistently proper diet.
As others have said, what you're specifically suggesting sounds bad. Your seat will have a correct height, dependent on the geometry of your frame and the length of your legs. Period. Get it wrong and your knees will complain.
But I can add something regarding fighting flab. I was around 105kg back in 2008, I've been about 75kg for the last couple of years. I have lost that weight purely through cycling.
As you might expect my legs have become extremely muscular. As regards my upper body though, I've not become amazingly muscular because I don't really work those muscles, however I have benefitted just by losing weight "all round" (for example, I still look down and see a gut, but t-shirt sizes used to start with X, now I'm a S/M, so something good has happened).
I guess what I am trying to say is this: set your bike up properly such that it is comfortable to ride, and keep putting the miles in. You will lose weight, but it will take time. To accelerate this, I can think of two things, (i) more miles (especially as your body becomes more able to cope), and (ii) your diet.
If you're specifically wanting to tone your upper body, I'd suggest doing some supplementary exercise, but cycling should give you all the lower-body and cardio you'll need.
Lastly, good luck. Obviously it is very much in your own hands, but know that it is possible to get rid of that flab.
To ignore what may be a bad idea in terms of bicycle posture and address what seems to be central to your question, which is the reduction of flab, you need to know this about flab: You cannot spot-reduce. With the exception of liposuction.
Your DNA determines where your fat ends up. You know how some ladies have normal upper bodies but have very large behinds? Yeah, you do. It's not because they're only active with their upper-half.
If you have flab and then develop very strong abdomen muscles, you will have an awesome six-pack covered by flab. If you want the six-pack to show through, you have to lose the fat. Muscle tissue does not transform itself into fat tissue nor vice-versa.
The only way to reduce flab in one area of the body is to lose fat period. @Carey Gregory already answered this as a comment but here it is as an answer.
I'd recommend the excellent Why We Get Fat by Gary Taubes. Adiposity explained.
Losing flab is a matter of eating less calories than you use on a daily basis. There is some debate about the 3500 calories = 1 lb of fat equation, but many studies have shown that it isn't Paleo, South Beach or (insert diet fad X here), but simple calorie reduction over time.
If you want to seriously lose the weight, then I would find a calorie calculator to get your basal metabolism, which will tell you how many calories you need to breathe in and out all day. Then add in the calories for all your activities, work, yard work, housework, play, etc. Then start using a food tracker such as myfitnesspal, and let the scale be your guide.
Bouncing your knees off your stomach won't do a thing for flab except give you a sore stomach.
