Originally posted by Khyryl:

have you tried to re-validate your steam files? this happens to me after my encounter with mouse not moving the camera view.

Thanks for trying to help. In this case, no I did not do that because I do not need to. Thanks to the OP I know what the problem is, it is the "Microsoft Flight Simulator" game (running in the background) causing the problem.

When I close the MFS, Valheim starts working fine.
When I re-open the MFS, Valheim starts having the same cursor-lock-not-working issue.
Clearly MFS is the root cause...

I purchased MFS today and for the last 9 hours it has been (very very slowly) installing the game in the background, and I was playing Valheim at the same time which caused the issue.