A simple handset was used with the mic and earphone jacks connected to the sockets in the front (above the USB slots).
A picture speaks a thousand words.. so its all in the screenshots.
Step 1: Change volumes settings as follows.
Step 2: Change skype options as follows
This might also help:
http://funwithlinux.wordpress.com/2009/04/20/fixing-skype-audio-problem-on-ubuntu-904/#comment-50
