To Yahoo's dismay, Google backed off to avoid a challenge from the U.S. Justice Department, which said it would sue to block the Yahoo deal to preserve competition in Internet advertising.
"The arrangement likely would have denied consumers the benefits of competition - lower prices, better service and greater innovation," said Thomas Barnett, an assistant attorney general who oversees the Justice Department's antitrust division.
Without Google's help, Yahoo now might feel more pressure to renew talks with Microsoft and ultimately sell itself for much less than the $33 per share that Microsoft offered in May. Yahoo shares were trading Wednesday afternoon at $14.20, gaining more than 6 percent in a move reflecting investor hopes that Microsoft might renew its pursuit.
Surrendering the chance to sell ads on Yahoo's popular Web site won't be a significant financial blow for Google, which already runs the Internet's largest and most prosperous advertising network.
The Mountain View, Calif.-based company's main incentive for entering the deal was to keep Yahoo out of Microsoft's hands. Google founders Larry Page and Sergey Brin also wanted to help Yahoo founders Jerry Yang and David Filo, who had encouraged them to turn their search engine into a business more than a decade ago.
But the capitulation marks a rare comedown for Google, which had been insisting for more than four months that the Internet would be a better place to do business if it were allowed to work with Yahoo.
"We're of course disappointed that this deal won't be moving ahead," David Drummond, Google's chief legal officer, wrote on a company blog. "But we're not going to let the prospect of a lengthy legal battle distract us from our core mission. That would be like trying to drive down the road of innovation with the parking brake on."
Yahoo said it wanted to fight the Justice Department in court, though it played down the impact Google's retreat would have on its turnaround efforts.
"This deal was incremental to Yahoo's product roadmap and does not change Yahoo's commitment to innovation and growth in search," Yahoo President Sue Decker told Yahoo employees in a Wednesday memo. "The fundamental building blocks of a stronger Yahoo ... were put in place independent of the agreement."
Google's management took a risk by agreeing to the Yahoo partnership in June, knowing the move would increase the government's scrutiny of Google's market power. Even though it is now walking away empty-handed, Google figures to remain in regulators' sights as it tries to expand.
"For the first time, Google has run into real opposition to its marketplace goals," said Jeff Chester, executive director of the Center for Digital Democracy, a consumer advocacy group. "Google is aware that its aggressive moves in the online advertising business are potentially contributing to damaging its brand. The perception of Google has changed."
The collapse of the Google-Yahoo alliance could become a coup for Microsoft.
Although it has publicly said it's no longer interested in buying Yahoo, Microsoft spent a lot of time and money trying to keep Google and Yahoo from coming together.
The world's largest software maker provided evidence that helped persuade regulators that the partnership would diminish competition. Microsoft also helped orchestrate the campaign that prompted major advertisers to lodge complaints against the partnership.
"The Department of Justice's finding is significant for advertisers, publishers and consumers, who voiced overwhelming concern about this illegal deal to law enforcement and policymakers," Brad Smith, Microsoft senior vice president and general counsel, said in a statement.
The Justice Department signaled it was considering a challenge to the deal in September when it hired veteran antitrust lawyer Sanford Litvack to review the case. Google and Yahoo responded with "discussions of various possible changes to the agreement," Drummond wrote on the Google blog. Those changes included proposals to limit the length of the agreement and to cap the search advertising revenue that Yahoo could generate from the deal.
Those concessions weren't enough to quell the regulators' concerns, however.
Now that Google is out of the picture, Yahoo's Yang will have to come up with another way to accelerate his company's growth and boost a stock price that has lost more than half its value since he became chief executive in June 2007.
If nothing else, Yang appears to have a bigger incentive to join forces with another tarnished Internet star, AOL. Yahoo has been discussing a possible acquisition with AOL's corporate parent, Time Warner Inc., for months. Google also owns a 5 percent stake in AOL.
But many Yahoo shareholders, including new board member Carl Icahn, have indicated they think the Sunnyvale, Calif.-based company should try to lure Microsoft back to the negotiating table.
Most industry analysts still believe Microsoft will make another run at Yahoo, particularly now that the company can be bought at a fraction of the May offer. Instead of buying Yahoo in its entirety, Microsoft might want just Yahoo's search engine, which ranks a distant second in usage behind Google's. Microsoft attempted to buy Yahoo's search engine shortly before the Google partnership was reached.
Under the terms of the proposed partnership, Yahoo would have drawn on Google's superior technology for some of the ads shown alongside the search results on its Web site. Yahoo would have pocketed most of the revenue generated from Google's ads.
The concept didn't pan out because Google and Yahoo combined would have controlled more 90 percent of the U.S. search advertising market, according to the Justice Department's analysis. Microsoft and the Association of National Advertisers, among others, argued the arrangement would enable Google to gradually increase advertising prices and exert more control over the flow of e-commerce.
Bob Liodice, head of the advertisers group, said Wednesday that with the agreement dead, "the search advertising marketplace will evolve unencumbered with increasing transparency and greater productivity. The marketplace will win."
Google and Yahoo said the advertisers' complaints were misguided because search ad rates are set through an auction-style system. What's more, the partnership was supposed to be non-exclusive, leaving an opening for others to vie to sell ads on Yahoo's Web site - including Microsoft.
Michael Liedtke reported from San Francisco.