Just so you rest assured, your computer is fine; it's doing everything it should be doing. When you connect a device via line-in, it will register under the System Preferences, but you will not hear its playback on the laptop's speakers unless you use a program that uses the line-in.
But... I'm really not sure what you're trying to accomplish by plugging an iPod to your laptop's line-in jack.
Are you trying to record audio from your iPod to your MBP? (this can be done, but why would you do that? Your iPod already plays digital music, and it would be a better choice to extract the digital file from the iPod so you don't lose any quality through the recording process)
Or are you trying to use your MBP as speakers for your iPod? (I don't recommend this, I personally think even a cheap $10-$20 speaker set is better than laptop speakers)
Only reason I would use line-in on a laptop is to record audio from another source (could be a record player or a tape player or whatever) to a digital file. If you want to do this:
1. Connect your device via the line-in jack.
2. Make sure your System Preferences -> Sound is set to line-in (which you did already).
3. Open up GarageBand. Create a new 'real' instrument and
turn on monitoring. When you hit play on the device, you should be able to hear it. Hit 'record' in GarageBand whenever you want for it to start recording your device's audio playback digitally.