Do you have the "Stereo Mix" (may be called System Mixer) in the Control Panel/Hardware and Sound and finally the Sound panel Recording section?
Check the Recording section panel. If Stereo Mix is there, enable it and select it as the default recording device. If its not showing, RIGHT click in an empty space in that panel and then click to show Disabled and Disconnected devices. Stereo Mix should now show up and you can enable it and set it as default recording device. That may take care of the problem.
Otherwise, use the System Restore and restore the PC back to a date when it did work. If its not some hardware problem, this should fix it.