The way I think it worked: Ross shuffled the cards. They added their own ordered cards to the top and bottom, and start going through the top ones. When they get to the end of the cards they added to the top, the little one takes a bunch of cards (enough to include all Ross' shuffled ones) and throws them away 'to save time'. He isn't all that casual in picking the amount to throw away, because he's being careful to cut it within a few cards of some pre-determined point in the pre-ordered bottom section. They have a signal (perhaps as simple as the words 'and this one?') for each card within some distance of his target cut point, so he can tell the fat guy where he's cut it. The fat guy hesitates for a second while remembering the signal, then remembers it's for Alexander Graham Bell, and continues on from that point in the order he's memorized.
The little guy gets Ross to cut 'about half' of the deck (so again they only have to learn signals for the cards close to the middle, especially easy because at this point there's only 10 or so left). When taking the cut half, instead of casually throwing them as he's been doing with other cards, he holds them for a bit, during which he catches a glance at the bottom card and gives the signal (again, it could be as simple as the specific wording of what he says) to the fat guy, who now again knows where in the order they are and continues on.
That's it.

How they got away with it: Their claiming they fooled P+T was just them differentiating between 'switching decks' and augmenting their deck. It was just sneaky, evasive answering, and that's probably why Penn was annoyed later (as I think someone said he was).

paraphrasing:
Penn: We saw that sneaky move you didn't want us to see. Shall I say more?
Them: Well...yeah....
Ross (cutting in to clarify): What kind of move are we talking about?
...
Penn specifies a 'deck switch', and they show the bag and box are empty, and Penn says 'well we saw you do it'.
...
exact quotes:
Victorians (interrupting Penn before he again gets more general than 'deck switch'): "I think it's worth saying at this point that every single card that Jonathan shuffled was on his hand in the order he shuffled it. That much we promise.
Ross: (carefully choosing words): you did not switch the deck then?
Victorians: We did not switch out that deck.
Penn: So there was nothing at all done from the time Jonathan shuffled the deck to the time Jonathan sat down and you put it on his hand?
Victorians: We did not switch out the cards that Jonathan shuffled.
...
Penn: Did you, just to monkey with us, do a move that looked tricky in order to lead us astray?
Victorians: No.

They just reframe the questions evasively, rather than saying yes/no. They didn't switch cards out, and they didn't switch the entire deck. They truthfully deny doing a 'deck switch' by defining that as something specific and distinct from augmenting the deck. That's all it is.

this was my exact same thought and i thought it as the conversation was going, and I have no idea why penn and teller didnt understand that. It was way easy to read by the way they were answering the questions they got