I had a similar experience on my HP Mini 1000 with WinXP. My Skype setup all of a sudden lost the MIC, although speaker output appeared to be normal. I found a less intrusive procedure that restored my PC. The following are the steps:
A. Right click the Speaker icon in the lower right system tray, and select Adjust Audio Properties.
B. Under Audio tab, select Volume for Sound recording.
C. For Internal Mic, select Advanced, then check "1 Microphone Boost" at the bottom of the dialog Window. Then, click Close.. X.. Apply, OK to get the setting stored.
When I tried Sound Recorder, I was surprised that I heard no playback sound, although the signal strength meter indicated that the Mic input was fine during recording. I then discovered that the speakers were somehow muted by themselves! After un-muted them, everything seemed to work fine including Skype's Echo / Sound Test call.