alright guys, I was able to solve the problem - here is what helped:
I had specified on ssh config file for both Windows Terminal and VS Code.
Also in the Remot SSH extension menu, there was still a range of old hosts stored.
I have now both created a specific ssh file for VS Code and deleted the deprecated hosts.
Now I am able to login successfully via VS Code over ssh.
Thanks you so much for helping to solve this one.