This is a kind of grey area, but the end result is equivalent, whether you call it passive voice or a stative verb + past participle as adjective. The active voice would be: Hills surrounded the village. It has the same basic meaning, but the reader's attention is brought more to the hills, rather than the village.
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Bamtoriin this case other prepositions like at, with, to areOther prepositions may be preferred, but that does not mean that "by" is never used in such cases.prefferedpreferred instead of "by"