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If it suddenly mutes playback while sound is being picked up by the microphone, set the Communications tab setting to "Do Nothing".
https://www.reddit.com/r/Steam/comments/51no97/steam_wont_pick_up_audio_from_otherwise_working/
This post made me realise that^. The guy's solution of "voicemeter" worked for me but I wanted to know the root cause of the problem. So, I tried another headset and got the same results. I knew the problem was somewhere with the jack. I opened my PC case, unplugged the cable labelled 'HD AUDIO' and re-inserted it back again and Voila! it worked.
I built this PC myself 2 months back so I that helped me troubleshoot the problem.
Hope this helps someone else out there