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If anyone else having this problem has a clue, please post a comment. I'm not sure which app or system update might be accidentally turning this on, but it could be related to the installation of 10.3.4, Skype, iChatUSBCam or turning on Speech Recognition. Even though none of these were checked, clicking the Master one for the mic on and off fixed the problem for me on both machines. So the headphone jack on your iPod is outputting the audio to your headphones that receive the audio to play it through the tiny speakers.
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Starting this up, there are three "Thru" checkboxes next to the microphone settings at the bottom in the Audio Devices pane. The headphone jack is another name for the audio output.
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It turns out after some poking around on the Apple Discussions site, that this setting now lives in the Audio MIDI Setup app in the Utilities folder. I remembered that earlier versions of OS X had a setting for playing the mic through the speakers, but I couldn't find this anymore. But then when I needed the mic for iChat, I had to go back and switch it again. I often had to just select a different input in the Sound Preferences to turn this off and be able to pump up the volume. I was confused in the last few months when the microphone on both my desktop G4 and Pismo Powerbook started playing through the speakers, leading to screeching feedback if I turned the volume or mic level up too high.
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