This is still a problem in Ubuntu 10.04 (beta)! Just luck brought me
here to find the solution with the .config directory. I think one should
be presented with a dialog on the next login where one has the
possibility of restoring the desktop folder entry (and settings) with a
checkbox to not show again. That would save users in use cases as mine.

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setting XDG_DESKTOP_DIR automaticallyto the user dir when Desktop is not 
available confuses users
https://bugs.launchpad.net/bugs/151576
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