It looked like Microsoft had a deal with AOL to replace Google as the AOL search engine of record and provider of online advertising services. This looked like a fantastic coup for Microsoft -- one that would make them a serious Google competitor on the search engine and online advertising front.

But that deal fell apart last week and culminated in a phone call on December 16 in which AOL told Microsoft the deal was off.

Google sweetened their offer and AOL went for it. Under the new deal, Google will pay $1 billion for 5% of AOL -- about twice the market value -- and will continue to share advertising revenue with AOL.

The stakes couldn't have been much higher for both companies. AOL accounts for about 11% of Google's revenue, and to have lost to Microsoft would have meant a significant shift in the search engine wars. Microsoft would have gained overnight credibility for both its search and advertising services.

On the AOL side, this deal stems recent criticism that the company is floundering with nowhere to go. Not only does this represent a re-valuation of AOL, but bolsters its efforts to diversify its services and move towards being something other than just a glorified ISP. For instance, Google has committed to promoting AOL's services in sponsored links, including a valuable collection of online videos that have been languishing.

As for Microsoft, it is back to the drawing board. Time will tell whether the AOL deal helps or hurts Google. But in the meantime Gates and company have been effectively blocked from using AOL to help them cut Google down to size.

==>Microsoft working on another deal?

Meanwhile, in a classic Microsoft move, the company let it be known they are in discussions with another "tier 1 internet company" to form an alliance to counter the Google/AOL deal.

In his blog, Ian McAllister, an MSN program manager wrote, "At the end of the discussion one of the people I was meeting with threw out a blanket offer to brainstorm other ways in which our companies might work together," McAllister wrote in the blog posting "He then stated that his company was willing to entertain ideas for working with Microsoft that would help our search and/or advertising business, with one of the goals being to prevent Google from dominating those spaces even more than they are now."

Nobody is saying who this other company is, and what they can bring to the table. Yahoo has been mentioned, but that is unlikely since they have little to gain from helping Microsoft win market share in an area in which they are so active.

Some industry analysts think it is likely the other company is a large high-speed Internet connectivity provider such as Comcast or AT&T Inc. Joe Wilcox, senior analyst with Jupiter Research suggests this is the logical move for Microsoft. "Microsoft would certainly benefit if say a Comcast or some other broadband providers with popular portals chose MSN as the default search," according to Wilcox.

These broadband providers are the very companies that are eating away at AOL's market share. As dial up subscribers shift to broadband they ultimately end up with a major provider like a cable company or telco. So it makes sense for Microsoft to pursue alliances with these providers.

Either way, it is not wise to count Microsoft out just yet.