Yahoo goes nuclear vs. Microsoft: Inks limited Google ad deal; Microsoft fires back

Update: Yahoo hit that big red button that could nuke any potential merger with Microsoft (or at least raise the price): An ad deal with Google.

As first reported in The Wall Street Journal, Yahoo has launched plans to carry search advertising from Google. The move is a "test" at this point, but could evolve into a broader partnership. Yahoo issued a statement on the matter:

Yahoo! Inc., a leading global Internet company, announced today that it will begin a limited test of Google Inc.'s AdSense for Search service, which will deliver relevant Google ads alongside Yahoo!'s own search results. The test will apply only to traffic from yahoo.com in the U.S. and will not include Yahoo!'s extended network of affiliate or premium publisher partners. The test is expected to last up to two weeks and will be limited to no more than 3% of Yahoo! search queries.

As previously announced, Yahoo!'s board of directors is exploring strategic alternatives to maximize stockholder value, including exploration of potential commercial business arrangements. The Company noted that the testing does not necessarily mean that Yahoo! will join the AdSense for Search program or that any further commercial relationship with Google will result. The Company further stated that it would not comment on the nature or timing of any potential relationship.

Microsoft counsel Brad Smith fired back in a statement:

Any definitive agreement between Yahoo! and Google would consolidate over 90% of the search advertising market in Google's hands. This would make the market far less competitive, in sharp contrast to our own proposal to acquire Yahoo! We will assess closely all of our options. Our proposal remains the only alternative put forward that offers Yahoo! shareholders full and fair value for their shares, gives every shareholder a vote on the future of the company, and enhances choice for content creators, advertisers, and consumers.

Notice what's going on here. Yahoo is talking to Google, but leaving its options open. Microsoft is simply annoyed. Here's what could happen:

• The Google test could freak Microsoft out enough to give up more dough for Yahoo;
• If Microsoft walks, Yahoo can proceed to outsource search ads to Google and boost its earnings by about 25 percent based on Citigroup estimates.

Quite the game eh? Dueling love letters and now Google. It's unclear whether Yahoo is just floating this trial balloon to see how investors react, but you have to give CEO Jerry Yang some moxie points here. Microsoft could and probably should call Yahoo's bluff here though. Yahoo has invested heavily in its search advertising platform via internal investment and acquisition. Would Yahoo throw all of that dough away just to avoid being a part of Microsoft?

The Journal reports:

The test under discussion, given its short time frame and limited scope, shouldn't stand in the way of any eventual sale of Yahoo to Microsoft, says the person familiar with the matter. But it could factor into the dynamics of the ongoing deal standoff, as a way for Yahoo to signal to investors its alternatives to the Microsoft deal and potentially as an irritant for Microsoft, which views Google as a major rival.

Microsoft CEO Steve Ballmer's annoyance meter must be maxing out.

Update: The New York Times is reporting that News Corp. may join Microsoft in a joint bid. Meanwhile, Yahoo is talking to AOL about a merger. The drama continues.