As part of the settlement, Microsoft will license its browsing software to AOL through 2010 at no cost. The companies also will collaborate on new digital media initiatives and ways to make their products mesh more seamlessly.
The deal announced Thursday ends legal fighting over AOL's antitrust suit, which was filed in response to Microsoft's efforts to bolster its Internet Explorer browser — now the world's dominant tool for navigating the Internet.
The settlement comes less than two months after Microsoft chairman Bill Gates called AOL Time Warner chairman Dick Parsons to discuss ending the lawsuit, Parsons said in a conference call.
"It's a forward-looking agreement," Gates said. "I was impressed with the fact that they are looking forward, and I'm very happy with what we've come up with here."
The agreement resolves a lawsuit AOL filed against Microsoft in January 2002 on behalf of its subsidiary, Netscape Communications. The complaint was one of several private antitrust lawsuits still pending against Microsoft over its competitive tactics.
AOL had alleged in the lawsuit that Microsoft used anticompetitive business practices to ensure the dominance of its Internet Explorer browsing software over Netscape's software. AOL argued that Microsoft made deals with computer manufacturers and others to shut out Netscape and quash competition.
Netscape, which once dominated the Web browsing market, now commands less than 5 percent market share, according to several industry measures. Internet Explorer has gained more than 90 percent of the market.
The settlement also allows AOL to license Microsoft's digital media and digital rights management technology, which is designed to prevent illegal copying and downloading of digital music, movies and other content.
But it does not require AOL to use that technology nor to use it exclusively. AOL now relies on Seattle-based RealNetworks Inc., a Microsoft rival, for viewing digital media online, and both AOL and RealNetworks said they will continue to work together.
The companies also will explore how to integrate their popular instant-messaging networks to allow users of one company's service to use the other's. But there is no schedule for when that will happen, Gates said.
Microsoft will also provide technical information on its current and future Windows operating systems to AOL to ensure that AOL products perform well there.
Analysts said both companies have much to like — debt-laden AOL Time Warner will receive a huge sum of cash, while Microsoft is able to remove a major legal burden, while also giving its digital rights management technology a public relations boost.
"It just kind of shows to me that AOL and Microsoft will have the same kind of relationship that (Microsoft has) with IBM," said Matt Rosoff, an analyst with Directions on Microsoft, a Kirkland, Wash.-based research firm. "They're not necessarily archenemies and will cooperate in certain areas."
Moreover, AOL scored a major victory with Microsoft's agreement to distribute AOL-branded Internet service software with the Windows operating system to smaller hardware manufacturers. The deal potentially expands AOL's reach to tens of millions of new computers annually, and helps AOL compete against Microsoft's MSN Internet service, said Richard Doherty, director of the research firm Envisioneering Group in Seaford, N.Y.
Ultimately, the agreement provides a groundwork for the world's largest software company to collaborate with one of the world's largest entertainment companies in the emerging world of digital media.
"It just seemed to me that the opportunity to do something smart for both companies — good for both companies and ultimately good for consumers and our industry — was present, so you take it," Parsons said.
By HELEN JUNG