The future of Yahoo! has been thrown into confusion after Google walked away from an agreed search advertising partnership to avert a "protracted legal battle" with US antitrust regulators.

Google's decision prompted fresh speculation that Yahoo! would be forced to return to a deal with Microsoft. Rumours online that Yahoo! chief executive Jerry Yang had resigned and that such talks were underway - immediately denied - sent Yahoo!'s share price rocketing.

Yahoo! struck the deal in June with Google to fend off an unsolicited takeover bid from Microsoft and to provide a much-needed revenue boost to the struggling search giant. But after months of protests from advertisers and increasing interest from regulators, David Drummond, senior vice-president and chief legal officer at Google, said it was not prepared to damage its reputation or relationships with clients by embarking on a legal battle against the US Justice Department.

"After four months of review, including discussions of various possible changes to the agreement, it's clear that government regulators and some advertisers continue to have concerns about the agreement," Mr Drummond said in a blog posting.

"Pressing ahead risked not only a protracted legal battle but also damage to relationships with valued partners. That wouldn't have been in the long-term interests of Google or our users, so we have decided to end the agreement," he said.

The tie-up would have allowed Yahoo! to display search ads sold by Google and to share revenue. It was estimated that Yahoo! could have made up to $800 million a year. But advertisers feared the joint venture would lead to a rise in prices for search ads.

Yahoo! was quick to reassure investors that the collapse of the deal would have minimal strategic impact but said it was "disappointed that Google has elected to withdraw from the agreement rather than defend it in court". Mr Yang was due to speak in a keynote appearance at the Web 2.0 Summit in San Francisco tonight.

Google's announcement pre-empted the Justice Department's confirmation of its opposition to the deal. Antitrust regulators said they would have taken legal action to block the alliance, claiming it would stifle competition in internet search advertising by controlling up to 90 per cent of the market. Google and Yahoo! are number one and two in the internet search market respectively.

Although the firms had offered a revised plan, the Justice Department "determined that such modifications would not eliminate the competition concerns raised by the agreement", according to yesterday's statement.

Thomas Barnett, head of the Justice Department's antitrust division, said that Google's decision to abandon the agreement eliminated the need to file an enforcement action.

Now that Google is out of the picture, Mr Yang will have to come up with another way to placate shareholders still incensed by management's decision to reject a $47.5 billion takeover bid from Microsoft six months ago. That deal was worth $33 a share. Despite a 7.64 per cent rise, Yahoo!'s share price was still only valued at $14.37 in afternoon trading. The stock has lost more than half its value since Mr Yang became chief executive in June 2007.

If nothing else, Mr 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, for months.

But many Yahoo! shareholders, including new board member Carl Icahn, think Microsoft is the way to go. 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. Microsoft has repeatedly said that there are no talks with Yahoo! but even as recently as mid-October Microsoft CEO Steve Ballmer said the deal still "made sense".

The capitulation marks a rare comedown for Google but it will not a significant financial blow for the company, which already runs the Internet's largest and most prosperous advertising network. "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."

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