Malvolio returns a ring Olivia claims Cesario left. Viola realises Olivia has fallen in love with her disguise and sees the impossible tangle clearly.
Malvolio catches up to Cesario on the street and returns a ring. Olivia has told him to say the young man left it at her house and should not have sent it; she wants nothing from Orsino, and this ring is no message to her. Viola accepts the ring, confused, because she left no ring.
Alone, Viola thinks it through. She gave no ring; Olivia must have sent it as a declaration of interest. This means Olivia has fallen in love with Cesario's disguise. Viola then runs through the full impossibility: Orsino loves Olivia; she loves Orsino; Olivia loves someone who is not what he appears to be; and Cesario, the object of Olivia's love, does not exist. "Poor lady, she were better love a dream."
She concludes that she cannot resolve this herself. The knot is too complicated for her to untangle. She leaves it to time.
The scene is short but it contains one of the play's most important soliloquies. Viola's reasoning is clear, methodical, and completely self-aware. She does not deceive herself, does not spiral into self-pity, and does not pretend the situation can be easily fixed. She names the problem accurately and accepts that the solution will have to come from outside her.
The phrase "Poor lady, she were better love a dream" is the scene's emotional centre. Olivia is in love with Cesario, and Cesario does not exist: there is no young man, there is only Viola in disguise. In that sense, Olivia's love is for a fiction, and the dream Viola names is exactly right. But the sentence is also touched with genuine sympathy. Viola does not laugh at Olivia's mistake; she pities it.
The contrast with Orsino is pointed. He delivers elaborate speeches about love without ever examining his own position clearly. Viola does the opposite: in a single short scene she sees the full structure of what has happened, including her own place in it, with complete precision. She is more honest with herself in this soliloquy than Orsino is throughout the entire play.
"O time, thou must untangle this, not I. / It is too hard a knot for me to untie" has a double meaning. On the surface it is a practical conclusion: she lacks the power to resolve the situation. But it is also a statement about the limits of intelligence in the face of feeling. Viola is the play's most clear-eyed character, and even she cannot think her way out of a situation created by love.