For some reason IIS does not like it when you set FUEL_ENV. If I set to "development," than rewrites do not work and get and ambiguous 404 error when I got to any URI other than the application root. FuelPHP works out of the box with included web.config settings so don't go changing a thing without some serious troubleshooting.
There is no reason why IIS rewrites would fail because of an environment variable, and on the Fuel side, it is only used to load a different set of config files.
In truth I was confused with server and environment variables.
As the documentation recommends to set [FuelPHP] Environment with server environment variables. Configuring environment variables on Apache or Nginx is easy; no problem.
However on Microsoft's Internet Information Services (IIS), configuring environment for each site is ridiculous. In the end I was only able to configure my local app running on Windows using FuelPHP application bootstrap as recommended in the docs. Anyways, thank you for your help like always.