In a statement, the software giant said it had offered to buy Sunnyvale, Calif.-based Yahoo! for $31 per share in cash or 0.9509 of a Microsoft share, with the total payment divided evenly between cash and stock components.

The offer represents a 62% premium to the target's closing stock price on the Nasdaq on Thursday, but falls short of Yahoo's 52-week high of $34.08 reached in late October.

The target responded in a statement saying it would "carefully and promptly in the context of Yahoo's strategic plans and pursue the best course of action to maximize long-term value for shareholders.''

Yahoo! shares have been in a free fall, losing about 32% of their value in the past year as the search engine pioneer has continued to lose market share to Google.

From a broader perspective, the news was a shot in the arm for the flagging stock market, which has been battered this year by the subprime mortgage market and a slowing economy. Dow Jones Industrial Average futures surged about 100 points to a gain of 146 within minutes of the announcement.

Redmond, Wash.-based Microsoft said online advertising is expected to grow from $40 billion in 2007 to nearly $80 billion by 2010, and together Microsoft and Yahoo! can gain a larger share of this growing market. They can also combine products to offer an unprecedented range of services to customers, and attain synergies of about $1 billion a year, said the statement.

"We have great respect for Yahoo!, and together we can offer an increasingly exciting set of solutions for consumers, publishers and advertisers while becoming better positioned to compete in the online services market," said Microsoft chief executive Steve Ballmer in the statement. "We believe our combination will deliver superior value to our respective shareholders and better choice and innovation to our customers and industry partners."

The statement includes a letter from Ballmer to Yahoo! chairman Roy Bostock and CEO Jerry Yang indicating that the two parties held preliminary talks a year ago; however, the Yahoo! board wanted to see if it could capitalize on the growth in online advertising on its own and whether the operating environment would improve.

"A year has gone by, and the competitive situation has not improved,'' said the letter.

Microsoft said it foresees the deal closing in the second half of 2008 and that it is willing to begin negotiations immediately. The offer, it said, is not dependent on financing. Microsoft intends to offer significant retention packages to Yahoo! engineers, key leaders and employees across all disciplines.

The offer could be the second tidbit of bad news in a day for Mountain View, Calif.-based Google. Late Thursday, the No. 1 search engine's shares declined in German trading after its fourth-quarter profit and revenue missed analysts' estimates on slower advertising sales.

Google shares fell 6.4%, to $527.92 in Frankfurt. The company, which had beat analysts' predictions 11 of the previous 13 quarters, said net income rose 17% to $1.21 billion, or $3.79 a share, from $1.03 billion, or $3.29 a share, a year earlier. That fell short of the $3.91 average analyst estimate in a Bloomberg News survey. Revenue increased 52%. - Peter Moreira