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I always check the box 'create desktop shortcut' when installing steam games, but recently it stopped creating them even with the box checked. I have tried the same thing OP describes (right-click game in Steam library, 'Create Desktop Shortcut') and get the same error 'Could not create shortcut. A shortcut is probably already on the Desktop.' but these shortcuts are not on the desktop.
It seems that the SteamService.exe is responsible for creating shortcuts, and that runs with SYSTEM credentials. If SYSTEM does not have permissions to write to your desktop folder, this could cause this error. If you've played with permissions, or did anything special with your user profile (like moving it to another drive), check the permissions to make sure SYSTEM still has full control.
My specific incompatibility is that I'm using folder redirection to keep various folders, including desktop, located on a NAS device. Since SYSTEM on the NAS isn't the same as SYSTEM on my local PC, SteamService.exe can't create the file and unhelpfully tells me that it "probably" already exists.
If anyone from Valve reads this, please consider moving this function to the frontend client instead of the system service. It's a little bizarre that a system service is responsible for creating desktop shortcuts in user profiles. It also seems like a poor security practice to me since highly elevated permissions are unnecessary for this. Lastly, that error message is a little lazy. If this condition was common enough to include that "probably" in the error message, it ought be common enough that the application should actually check and see if this is the case or not.
Your reply makes me suspect that you work in IT support IRL.
I recently had the same problem after moving my OS to a SSD drive but keeping my steam directory in my old HDD drive. However "System" have all the permission to modify the directory "Desktop".
My fix was to execute steam as Administrator, and the shortcut creation worked.
Hope that it could help someone =)
Hey thanks a lot, that worked for me! =)