I've still got the same issue (Oneiric). I'm using XDM and EvilWM.

As a work around, what I do is:

  - Alt+Ctrl+F1
  - login
  - /etc/init.d/xdm restart
  - login via XDM
  - kill the F1 console

I think the encryption is correct. By logging in via a console and then
restarting XDM, it sees the unencrypted home directory and carries on.

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https://bugs.launchpad.net/bugs/783050

Title:
  unable to use keyboard after xdm login

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