Not sure if the preferences are the same for Lion as they were in previous OS X's, but go to: Apple > System Preferences > Sound > Input and check to be sure that the Internal microphone is selected (highlighted) and then adjust the Input volume level.
Thanks for offering a solution. I checked the System Prefs and compared it to my MacBook Pro. On my laptop the volume moves and on the iMac it doesn't. I guess the issue must be the microphone - I have always used a Snowball in the past so never needed the internal mic.
It's pretty rare to loose an internal mic, however if the iMac has ever been serviced, then it could be that it was damaged or not properly reconnected. In either case you might want to run the Extended Apple Hardware Test and see if it finds a hardware problem with the internal mic. > Intel-based Macs: Using Apple Hardware Test