microphone picks up "line out" and creates a feedback mess

This is not a 'microphone too close to the speakers' problem. This is a software conflict or a settings issue.

I live on skype and have used my headset/microphone setup with no issues for 2 years with my current computer. XP is the operating system...nothing fancy...just a standard computer. I'm using cheap walmart headset and microphone with two plugs...one into mic pickup and the other into the speaker pickup. No other speakers connected to the computer. I get the same results plugging into the pic ups on the front or the back of the computer.

I was away and while I was gone my 5yr old niece used my computer for many sessions of Disney's play house and now I've got this problem.

(1) The microphone constantly mutes itself. Every time a skype call comes in I have to open the volume control and un-mute the microphone. I'm guessing this setting gets tripped because of the following issues I'm about to explain.

(2) When I go to Control Panel -> Sounds and Audio Devices -> Voice -> Test Hardware I get the following result. The first test registers sound through the mic. On the second test (where you're supposed to hear yourself through the headset with a slight delay) I can make a noise and it echoes louder and louder and makes a feedback loop. The output to the speakers is being fed directly to the mic input.

(3) When I am on a skype call any noise my computer makes (IM beeps, music I'm listening too, etc) is heard by whomever I'm talking to...again...all output to the speakers is being fed directly to the mic input.

(4) Before these problems began you could wear the headset and it would sound as if everything was dead until you began using skype. Now I have to listen to myself breath and I'm about to go nuts.

Any ideas or help would be greatly appreciated.

Thanks,