SAN FRANCISCO -- America Online on Tuesday agreed to sell a 5 percent stake to Google Inc. in a $1 billion deal that deepens the ties binding two of the Web's most popular sites while thwarting Microsoft Corp.'s efforts to grab a larger piece of the booming Internet advertising market.
Approving the expanded alliance had been considered a mere formality since last Friday when AOL's corporate parent, Time Warner Inc., abruptly ended several months of negotiations with Microsoft, which had hoped to supplant Google as AOL's main advertising partner.
Many of the details, including a plan that may display more graphical ads on Google's traditionally sparse Web pages, had been leaked to the media in the last few days. None of the so-called banner ads will appear on Google's home page or alongside its primary search results.
There was one significant new twist in Tuesday's official announcement: users of AOL's Internet-leading instant messaging service will be able to communicate with the users of Google's 4-month-old service. Microsoft and Yahoo Inc., another major rival of both Google and AOL, plan to link their instant messaging services next year.
Google's aggressive courtship of AOL illustrates how seriously it regards the looming threat posed by Microsoft as the world's largest software company eyes the lucrative field of online search -- a specialty that Google has so far dominated to emerge as a corporate powerhouse in its own right.
"This is a very big deal for us, something I have wanted to do for a long time," Google CEO Eric Schmidt said Tuesday.
The battle for AOL illustrates the rising importance of the online advertising market as a steadily growing number of people spend more time surfing the Internet instead of watching television, listening to the radio or reading newspapers.
About $12 billion is expected to be spent on Internet advertising this year, a 25 percent increase from $9.6 billion last year, according to the Interactive Advertising Bureau, a trade group. By 2010, worldwide spending on Internet ads could swell to $55 billion, with Google and Yahoo positioned to be the biggest beneficiaries, predicted Piper Jaffray analyst Safa Rashtchy in a report earlier this month.
Had Microsoft been able to win over AOL, it would have become a much more prominent player in Internet advertising while dealing a financial blow to Mountain View, Calif.-based Google.
AOL accounted for about $420 million, or 10 percent, of Google's revenue during the first nine months of this year. After subtracting the commissions paid to AOL, Google wound up keeping about $63 million of the ad revenue, estimated Internet analyst Mark Mahaney of Citigroup.
AOL's rebuff of Microsoft also demonstrates how much it prizes its relationship with Google, which has built a network where more than 200,000 businesses and Web sites now bid for the right to have their ads distributed across the Internet. Google began distributing ads to AOL three years ago.
In an interview Tuesday, Time Warner Chairman Dick Parsons cited AOL's past relationship with Google as a "compelling" reason to further extend their business ties. "Do I think this is the best way to help AOL realize its full potential? Yes," Parsons said.
New York-based Time Warner has been under pressure to boost its stock price by hedge fund investor Carl Icahn, who is leading an unhappy group of shareholders with about a 3 percent stake in the company.
In a letter to Time Warner's board Monday, Icahn had balked at the Google investment, citing an analyst report that theorized the company might be better off selling an AOL stake to another suitor, such as Microsoft or online auctioneer eBay Inc.
To trump Microsoft, Google is making a series of concessions, including giving AOL the right to tap Google's vaunted search engine technology to sell ads on its own Web site.
Google is also giving AOL a $300 million credit to buy ads on its rapidly growing Web site -- a vehicle that could help AOL attract more traffic as more of its dial-up subscribers drop their service.
Through November, Google operated the Web's fourth most popular site with 85.5 million unique U.S. visitors followed by AOL with 74.3 million visitors, according to Nielsen/NetRatings. Yahoo ranked No. 1 with 104 million visitors, followed by Microsoft at 96.1 million and MSN.com at 91.3 million.
AOL hopes to attract even more visitors with the help of Google's search engine. The deal contains a provision requiring Google to help make AOL's content more visible to its search engine.
That arrangement already is raising questions whether Google will rig its algorithms so that AOL ranks higher in its search results -- a prized position that Google has repeatedly said can't be bought.
In Tuesday's interview, Schmidt brusquely dismissed that notion. He said Google just wants to ensure some AOL material that's difficult to index, such as video, finds its way into the search results.
"We are not giving (AOL) preferential treatment, nor did they ask for it," Schmidt said. "I am making this clear: we will not let a business deal interfere with our search engine results."
Cinching the deal wasn't cheap for Google, costing the company 13 percent of its $7.6 billion in cash. But it's something Google could easily afford, analyst Mahaney said, given that the company's cash flow could generate another $2.2 billion next year.