But industry watchers say the lost bid also shows that Microsoft, while eager as ever to best its competitors, saw the perils of going to what it considers to be unreasonable lengths to make a deal work.

"I think they've learned that you don't do a deal at any price just to do a deal. You do a deal that makes sense for you," said analyst Michael Gartenberg with Jupiter Research.

AOL parent Time Warner Inc. and Google were expected to announce, as early as Tuesday, an extension and broadening of their search and advertising partnership. One official familiar with Time Warner's position in the talks said the five-year deal would involve Google paying $1 billion for a 5 percent stake in AOL.

Microsoft wasn't interested in a cash investment in AOL, officials familiar with both sides of the talks said. Microsoft had tried to persuade AOL to set up a shared online advertising business in which both companies held a stake, according to a person who is familiar with Microsoft's side of the discussions.

The officials spoke on condition that they are not named because the discussions were confidential and the deal hadn't been formalized.

Microsoft declined to comment.

Still, the renewed partnership between two of Microsoft's online competitors is certainly a blow to the Redmond software titan, which was late to develop its own search engine technology and is now trying to make headway in the hot market of selling online advertising. A deal with AOL would have jumpstarted both efforts.

"It slows their progress. It doesn't eliminate their progress," said Marianne Wolk, research analyst with Susquehanna Financial Group.

The deal also would have been a coup if only because it would have meant a loss for Google. The company is Microsoft's nemesis because it is at the forefront of many Web-based efforts that could eventually pose a massive threat to Microsoft's core businesses.

"It clearly would've given them bragging rights and it would have done Google a lot of damage," said analyst Rob Enderle. "It (would have been) a huge benefit to them to take Google down a peg."

On the other hand, Enderle said the stakes were significantly higher for Google to make a deal work.

AOL is Google's biggest customer, accounting for about $420 million, or about 10 percent, of Google's revenue during the first nine months of this year, according to regulatory filings. Losing the deal would have represented a blow to both the company's revenue and its image as the search market leader.

Also, while online search technology is at the center of Google's business, Microsoft's MSN online unit represents just a portion of its business and the company still makes the bulk of its money from its Windows and Office franchises.

"For Microsoft it was kind of a nice to have," Enderle said. "For Google it was a must have."

Besides paying $1 billion, Google agreed to integrate AOL's video clips in its fledgling Google Video service and highlight AOL's properties among the search engine's keyword ads, also known as sponsored links.

According to the official with knowledge of Time Warner's position, AOL would get an undisclosed amount of credit to buy such ads on Google's network. For the first time, Google would display graphics as part of sponsored links - such as icons next to links to new AOL concert footage.

AOL would be able to sell keyword ads and have them appear only on AOL sites, instead of telling potential advertisers to buy from Google directly. Google also agreed to have AOL sell display ads Google offers on third-party sites.

In exchange, AOL will continue providing Google's search engine to its subscribers.

For AOL, a deal with Microsoft would have been considerably riskier, since Google's online advertising business is more firmly established and Microsoft is the relative newcomer.

"Given that there was a fairly successful relationship already established between AOL and Google, the old maxim of 'if it ain't broke, don't fix it' certainly would be coming into play," said David Garrity, director of research for Investec's U.S. operations.

Still, Garrity said the fact that Microsoft was unable to strike a deal shows that the software giant, which recently announced a massive push into Web-based software and services, still has work to do if it wants to compete effectively with Google, Yahoo and others on the Web.

In addition to its efforts to gain popularity as a search engine provider and sell more Internet advertising, Microsoft also is in the midst of launching a new set of Internet-based offerings for things like checking e-mail and doing business tasks.

The moves come amid criticism that Microsoft, long the industry's 800-pound gorilla, is losing traction against younger, more nimble competitors. Microsoft recently announced a reorganization that was aimed in part at addressing such bureaucratic woes.

"I do think from a cultural standpoint that Microsoft is not yet quite thinking in the way that they need to competitively," Garrity said.