The ten year agreement gives Microsoft an exclusive license to Yahoo's search technologies, which Microsoft will be free to integrate into its own. The deal does not extend to Internet display advertising.
Microsoft will compensate Yahoo for traffic generated on Yahoo's sites under a revenue sharing formula. Yahoo said it expects the arrangement to add $500 million to annual operating income and $275 million to cash flow while cutting capital expenses by $200 million.
"This agreement comes with boatloads of value for Yahoo, our users, and the industry," said Yahoo CEO Carol Bartz, in a statement. "I believe it establishes the foundation for a new era of Internet innovation and development," said Bartz.
Microsoft and Yahoo have been working on a deal for more than a year. At one point, Microsoft offered to buy Yahoo outright. That offer was rejected by former Yahoo CEO Jerry Yang. Yang was replaced by Bartz in January—a move that paved the way for renewed talks.
Microsoft CEO Steve Ballmer hailed the agreement as a chance for his company to expose its search tools, including the new Bing "decision engine", to a wider audience and make inroads against current market leader Google.
"Through this agreement with Yahoo we will create more innovation in search, better value for advertisers, and real consumer choice in a market currently dominated by a single company," said Ballmer.
"Success in search requires both innovation and scale. With our new Bing search platform, we've created breakthrough innovation and features. This agreement with Yahoo will provide the scale we need to deliver even more rapid advances in relevancy and usefulness," Ballmer said.
Google presently controls about 65% of the U.S. search market, while Microsoft owns only about 8% of the market, according to the most recent numbers from ComScore. Yahoo, the number two player, holds 20% of the market.
The companies said they hope to close the deal by early 2010, but noted that it's likely to come under close scrutiny by federal antitrust regulators and other authorities.