This is always a difficult question - to 'foretell' what could have been for a top cricketer depending on his advancing age and his diminishing form. We did that once or twice earlier (most notably with Dada in 2005).... we did not spare Sachin in 2006 either...(hard to believe now) - and look what happened.
Nevertheless this was my reply, and it is based mainly on Test matches:
As per my observations for the last 1 year it was time to go for Murali. I checked the stats in cricinfo and they supported me: From 1st Jan 2009 till date (18th July 2010), Murali has taken only 23 wickets in 8 tests against opposition (excluding Ban or Zim). His average in these tests is 47+ (almost double his career avg) and his strike rate was 89 (much increased from the customary 50's). He was too great a bowler to be bowling to ignore that year-and-a-half long signal - getting to milestones matters less than being of value to the team. In this case, probably he is only just holding his place in the team (but still not a burden) - and a great cricketer needs to step back when it comes to that stage.
As usual I backed myself up with stats there. But I confess that I would not have been able to state the above with any conviction had Murali himself not called it a day.
And what about limitd overs cricket? Well I believe he may just have a role to play in the 2011 50 overs WC. but T20 is also going beyond him...at least that was my first thought while watching Murali a few times in Chennai Super Kings matches of IPL-3. He was not quite the Murali we saw in the first edition of IPL.