I have a somewhat unusual configurtion (NTEmacs plus MinGW/MSYS), but I experience a similar result.
The problem on the local side (Emacs shell buffer on Windows) seems to be when a pass phrase or password (non-echoing) prompt is issued. If I use ssh-agent to cache a credential I can then use ssh to connect to a remote host. After connecting I get a message "Pseudo-terminal will not be allocated because stdin is not a terminal" but then I can issue commands to the remote host. No interactive prompt appears but output from the remote shell does return to the Emacs shell buffer. "stty -a" on the remote host says "stty: standard input: Invalid argument"