OK.
I think I managed to solve it though I have no idea why this works.
I reinstalled UBUNTU. This time, when I installed all the updates, I 
de-selected all the kernel updates (everything which starts with "linux...".
There were 5 of these.
After that I installed all the remaining 5 updates.
Sound is working.
Hope it helps someone.

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Sound is not working at all - Ubuntu 7.0.4 - intel 82801CA-ICH3
https://bugs.launchpad.net/bugs/127599
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