The compromise spares Yahoo from more bickering with Icahn, an acerbic billionaire who had spent the past two months spearheading a rebellion to replace the Internet company's entire board in retaliation for its rejection of Microsoft's $47.5 billion takeover bid in May.
The duel had been scheduled to culminate in a shareholder vote at Yahoo's Aug. 1 annual meeting.
It now appears there will be fewer fireworks at that gathering, although some Yahoo shareholders are still expected to vent about the board's inability to get a deal done with Microsoft after six months of wrangling.
The main order of business will be the cease-fire giving Icahn three of the 11 seats on Yahoo's board, which will be expanded to make the deal possible.
Eight of Yahoo's current nine directors will be retained, leaving the company's current regime - headed by Chairman Roy Bostock and Chief Executive Jerry Yang - in the driver's seat.
Robert Kotick, the CEO of video game maker Activision Blizzard Inc. and a Yahoo director for five years, will surrender his seat as part of the agreement.
But the compromise, negotiated over the weekend, doesn't necessarily settle Yahoo's fate, which has been unclear since Microsoft made its first unsolicited offer in January.
Icahn, who owns a 5 percent stake in Yahoo, emphasized he still believes a sale of all or part of Yahoo may still be the best way for the Sunnyvale, Calif.-based company to lift its sagging stock price.
And with more than $1.5 billion invested in Yahoo, Icahn isn't likely to be satisfied with the status quo. He paid an average of about $25 per share for his Yahoo holdings, meaning he will sustain a loss unless the company's stock perks up.
Yahoo shares fell 78 cents Monday to finish at $21.67 - well below the $33 a share that Microsoft CEO Steve Ballmer dangled in early May before withdrawing the bid after Yang sought $37 per share.
Icahn's involvement on corporate boards hasn't always paid off. For instance, he won three board seats at Blockbuster Inc. in May 2005 and, since then, the movie rental chain's stock price has plunged by about 75 percent.
Microsoft didn't respond to requests for comment Monday, but has previously indicated it remains interested in exploring a deal with Yahoo, especially if the negotiations were handled by a new board.
Having been repeatedly rebuffed by Yahoo so far, Microsoft has been reported to be discussing a possible acquisition of Time Warner Inc.'s AOL. Microsoft wants to strengthen its Internet business to challenge Google Inc.'s dominance of the online search and advertising market.
Standard and Poor's Internet analyst Scott Kessler doubts Microsoft will buy Yahoo, but interpreted the Icahn agreement as a sign that the current board realizes it needs to shake things up even more than Yang has already done since he became CEO 13 months ago.
"It makes it more clear to shareholders that Yahoo's board is amenable to new ideas and is willing to do what's necessary to get the business back on track," Kessler said.
Some shareholders still want more even more new faces on Yahoo's board after watching the company's market value plummet by more than 40 percent, or about $20 billion, since the end of 2005. All but one of Yahoo's directors - Maggie Wilderotter - have been on the board since 2005.
"I am still very angry at this board and I am sure other shareholders feel the same way," said Eric Jackson, who manages a hedge fund, Ironfire Capital, that's organizing a protest on behalf of about 150 Yahoo stockholders with about 3.2 million combined shares.
Jackson said his group plans to punctuate its displeasure by opposing the re-election of four Yahoo incumbents - Bostock, Ronald Burkle, Eric Hippeau and Arthur Kern. More than 30 percent of Yahoo's shareholders voted against Bostock, Burkle and Kern at last year's annual meeting, with Jackson leading the fight.
The shareholder angst could intensify if Yahoo's second-quarter earnings, due Tuesday, disappoint Wall Street. Analysts are bracing for a letdown after Google and Microsoft indicated last week that the deteriorating economy is hurting the online ad market.
After spending weeks ridiculing Yang and the rest of Yahoo's board, Icahn apparently realized he had little hope of gaining control of the company.
Things began to unravel July 12 when Yahoo rejected Microsoft's latest proposal to buy its online search operations in a complex deal assembled in concert with Icahn.
Then, on Friday, Legg Mason Capital Management Inc. became the first major Yahoo shareholder to publicly declare its support for the incumbent board. Legg Mason, which controls 4.4 percent of Yahoo shares, also encouraged Yahoo and Icahn to negotiate a compromise.
Yahoo's new board may include a possible successor to Yang, whom Icahn had threatened to fire if his attempted coup had been successful.
Besides taking a board seat himself, Icahn will be able to recommend two other directors who must also be accepted by Yahoo's nominating committee.
To fill those spots, Icahn will choose from the eight men he had already nominated and one new candidate - Jonathan Miller, the former CEO of Yahoo rival AOL. Miller is the kind of seasoned CEO that Icahn envisioned for Yahoo.
But throwing Miller into the mix of Yahoo's new directors was Yang's idea, according to a person familiar with the discussions who asked not to be identified because the talks were considered confidential.
While sparring with Icahn and Microsoft, Yang had also been talking to Miller - a partner at the technology investment firm Velocity Interactive Group - and decided he would be a valuable addition to the board, this person said.
Icahn didn't return a call seeking comment Monday.
Yang, who co-founded Yahoo at Stanford University in 1994, has been trying to steer a turnaround. He believes Yahoo can dramatically accelerate its revenue growth in the next two years by extending the reach of its ad network and relying on Google's superior technology to sell some ads for Yahoo's site.
Icahn seems unlikely to back off his criticism of Yang, Kessler said, although his misgivings may now be expressed more privately.
Darren Chervitz, who co-manages a fund that owns about 75,000 Yahoo shares, predicted Yang will be out as CEO by the end of this year. If Microsoft doesn't buy Yahoo, he expects Icahn to renew his call for Yang's ouster.
"Yang is a reasonably smart person, but it wasn't until Microsoft entered the picture that he really started to make some changes," said Chervitz, who helps runs the Jacob Internet Fund. "I don't think this is the right team to lead Yahoo. I don't have a lot of faith in it."
