Peter Gabriel spent last week in his Real World studio in Wiltshire, mixing tracks for the DVD of his recent Growing Up tour. The show was a visual spectacular, featuring a circular stage with a revolving perimeter, a cloth egg that descended from the lighting gantry and a transparent sphere that allowed Gabriel to roll himself around the stage.

The Charterhouse-educated Gabriel has always been an unusual and thoughtful kind of rock star. After abandoning the band Genesis in 1975, he went on to write a haunting song about Steve Biko, the activist who died in an apartheid jail; to found the Womad festivals that have done much to popularise “world” music; and to make the acclaimed Sledgehammer video with the dancing vegetables, voted the best of all time by Rolling Stone magazine.

But it was not Gabriel’s music that was winning applause from his industry last week. Rather, it was a deal that his internet music company has struck with Microsoft that could usher in a new era of digital music in Europe and help the record companies to fight back against illegal downloading and copyright piracy.

Microsoft’s MSN site and Tiscali, the Italian-owned internet service provider, are working with Gabriel’s OD2 to offer online music on a pay-as-you-go basis. The monthly subscriptions demanded by existing music sites have proved unpopular with consumers, and have encouraged millions of otherwise law-abiding citizens to turn to sites that allow them illegally to download their favourite tracks for free.

The new pay-as-you-go services will allow music fans to buy individual tracks for less than £1, without having to make a costly longer-term commitment. This is regarded as a crucial step in turning the tide against the music pirates.

The rapid growth of the illegal services has hit the record companies like a sledgehammer. The big labels claim to have lost $1 billion in revenue last year as CD sales stalled.

The scale of the problem is illustrated by the latest quarterly figures from the British Phonographic Industry, which show a 40% collapse in the number of singles sold since last year.

Singles are most vulnerable because it takes much less time to download a single track than a whole album. But as high-speed broadband internet access becomes more widely available, the online threat will spread to albums.

Gabriel says most musicians rely on record sales for most of their income. “If that’s gone, so are they effectively. A lot of people are losing their jobs, a lot of musicians are being dropped by their labels.”

About the only good news for the music industry in this long-running battle is the early success of iTunes, an online service in America launched by the Apple computer company in April. By charging only 99 cents per song, iTunes has persuaded consumers to pay for music they download — more than 6.5m times in its first three months of operation.

This is tiny in the context of the amount of file-swapping taking place on the rogue sites, led by KaZaa, Morpheus and Grokster, which attract more than 20m users each week. But it does show that consumers are prepared to pay for online music if it is priced reasonably.

MSN Music and Tiscali Music are the first European equivalents of iTunes. The iTunes service is currently available to only the small minority of Americans who use Apple’s Mac computers. In Europe, as elsewhere, most computer users have machines running on Microsoft Windows.

Potentially, this puts Gabriel and OD2 in an enviable position. OD2, which has licensing deals with all the big five record companies, is effectively the engine room behind MSN and the other music sites it supplies, including HMV, Freeserve and MTV. It manages the transfer of digital rights, and ensures that artists and record labels get paid.