I have the exact same problem, it is finally working now!
1. Go to Control Panel -> Sound Effect Manager (I think this comes with my sound card, not sure if you have this option)
2. Select Speaker Configuration, and select "2 channel mode for stereo speaker output".
3. Select Sound and Audio Devices -> Voice tab
4. Click on Volume under Voice recording session
5. Check Select checkbox on Line In, the Microphone checkbox will uncheck itself
6. Click on Test hardware. There you go, it works.
The weird thing is that now if you check the volume again, the Select checkbox is checked on the microphone, not line in. But it works! Btw, I am using WinXP.