I have moved the emacs window to the right a little.
In reality it is exactly on top of the shell window.
I have also shrunk it to make the screenshot smaller.

>>>>> "PS" == Phil Sainty <psainty@orcon.net.nz> writes:
PS> Are you saying that if you create a second file, /tmp/m2 which does
PS> *not* have any file-local variables, and you go to your terminal and
PS> run "emacsclient /tmp/m2" and type "y" that it inserts the character
PS> "y" into the "m2" buffer;

Yup. That's normal too.
I see in the minibuffer
"When done with a buffer, type C-x #"
(which is just a statement, not a question waiting for me to answer.)

PS> but if you run "emacsclient /tmp/m" which has the file-local var and
PS> you type "y" it gets inserted into the
PS> terminal window?  And you are doing everything else exactly the same
PS> way, so that the sole difference between the two tests is that whether
PS> or not the file has a file-local variable?

Correct.

PS> To me it still sounds like a matter of OS window focus, but I can't
PS> fathom why those two tests would result in different windows being
PS> focused by the window manager.

I'm just using icewm.
If I do emacs -Q -f server-start &
it makes a window anchored at the upper left,
and covers up my xterm,
so I don't even see where my yyyyy's go too.

PS> To be clear, I've already tried and failed to reproduce your problem,
PS> so not everyone is seeing the same thing as yourself.

Well there is a hollow prompt there in the minibuffer of my image above.
That means input is not going to be seen by emacs.

PS> It would be easier to understand what's happening if you could confirm whether of
PS> not the Emacs window actually has focus (which is why I tried to get
PS> that information via a more-detailed recipe a in an earlier message).

Well my yyyyy's end up in the shell, which is underneath the emacs
window asking me the for the y,n.