I've been on Windows 7 for a while, so I'm doing this off memory.

1. Open your volume controls by double-clicking on the speaker icon near your clock.
2. Go to the File menu and then Properties.
3. Switch to Recording
4. Ensure that "What U Hear" or "Stereo Mix" or "Wave" is enabled.
5. Click OK
6. Now checkmark under "What U Hear" to set it as the recording input.
7. Adjust your internal system volume as you normally would (ignore your physical speakers).

Let me know if that fixes it for you. This will record much better than running an audio cable like spaghetti.