Microsoft has dropped its three-month-long pursuit of Yahoo, taking Microsoft back to square one in its quest to boost its online business.

"We continue to believe that our proposed acquisition made sense for Microsoft, Yahoo and the market as a whole. Our goal in pursuing a combination with Yahoo was to provide greater choice and innovation in the marketplace and create real value for our respective stockholders and employees," said Microsoft CEO Steve Ballmer.

Microsoft had raised its initial bid by about US$5 billion (£2.5 billion), or to $33 (£16) per share, but that didn't convince Yahoo to accept the revised offer, as Yahoo wanted $37 per share, Microsoft said. "After careful consideration, we believe the economics demanded by Yahoo do not make sense for us, and it is in the best interests of Microsoft stockholders, employees and other stakeholders to withdraw our proposal," said Ballmer.

In response, Yahoo issued a statement reiterating its position that Microsoft's offer was too low, and saying that many Yahoo shareholders agreed with its position.

"Yahoo is profitable, growing, and executing well on its strategic plan to capture the large opportunities in the relatively young online advertising market," said Roy Bostock, the chairman of Yahoo's board.

Yahoo CEO Jerry Yang said that "with the distraction of Microsoft's unsolicited proposal now behind us," Yahoo can continue with "the most important transition in our history."

All parties with a stake in the deal had been waiting for Microsoft to announce its next move, after Yahoo failed to agree to a deal by last Saturday, the deadline Microsoft had set three weeks earlier.

But Microsoft stayed silent for days, as observers speculated whether it would walk away or prepare a hostile takeover. However, on Friday anonymously sourced reports in The Wall Street Journal and The New York Times said that Microsoft and Yahoo had turned a corner and were for the first time negotiating merger terms in earnest.

Ultimately, it seems that Microsoft's management, fatigued by Yahoo's resistance and demands, decided that engaging in a proxy fight to oust Yahoo's directors would be an arduous and nasty process. After all, for Microsoft, the goal of the massive acquisition was to quickly become a mightier competitor to Google in online advertising.

"This approach would necessarily involve a protracted proxy contest and eventually an exchange offer. Our discussions with you have led us to conclude that, in the interim, you would take steps that would make Yahoo undesirable as an acquisition for Microsoft," Ballmer wrote in a letter he sent Saturday to Yang.

As soon as Microsoft announced its bid for Yahoo on 1 February - valued at US$44.6 billion at the time - Yahoo's management began seeking and considering alternatives.

By the time Yahoo's board formally rejected the unsolicited offer on 11 February, saying it undervalued the company, Yahoo's stock price had risen to $29.87, erasing the offer's premium. The next day, Microsoft hinted in a letter to Yahoo that it wouldn't shy away from attempting a hostile takeover.

Meanwhile, several media reports appeared - all attributed to anonymous sources - that Yang was holding conversations with Google, AOL, Disney and News Corp, exploring alternative deals that would strengthen Yahoo's business and thus relieve the pressure to accept Microsoft's offer.

On 5 April, Microsoft, clearly impatient, threatened Yahoo's board of directors with a proxy battle if it wouldn't agree to a buy-out in the next three weeks. That deadline passed last Saturday.

No alternative deal ever materialised for Yahoo, except for a very limited, albeit eyebrow-raising, test that saw Yahoo run Google ads along with some search engine results on Yahoo. Observers speculated that the test, announced on 9 April, could lead to a full-blown outsourcing of Yahoo's search ad business to Google, a move that financial analysts believe could boost Yahoo's revenue. Press reports last week indicated that Yahoo and Google might still enter into such a deal.

This possible deal with Google played a big part in Microsoft's decision to walk away, Ballmer wrote in his letter. If Yahoo outsourced search advertising to Google, the deal would "fundamentally undermine" Yahoo's long-term viability, he wrote.

"This would also fragment your search advertising and display advertising strategies and the ecosystem surrounding them. This would undermine the reliance on your display advertising business to fuel future growth," Ballmer wrote.

Over the past couple of months, there have been plenty of reminders of why Yahoo found itself an acquisition target. The most concrete of these was on 12 February, when Yahoo started laying off about 1,000 staffers. Meanwhile, prominent executives like Bradley Horowitz, vice president of product strategy, voluntarily departed, in Horowitz's case to arch-rival Google.

As time passed, Microsoft's hopes of a swift acquisition and integration evaporated. Ballmer maintained all along that the offer was fair and seemed perplexed that Yahoo didn't jump to accept it. At the prospect of a dragged out proxy fight, to be followed by a complicated and lengthy integration of MSN and Yahoo, Ballmer apparently grew increasingly disenchanted.

If Microsoft had $40-plus billion to spend on Yahoo, it can certainly go shopping for the many startup and niche companies that have gained traction in the Web 2.0 space in areas like social networking, social news, video, Web-hosted applications and mobile advertising.

Considering Ballmer's well-known competitive nature, he will dust himself off and draw up another plan, because one thing is clear: while he is giving up on acquiring Yahoo, he is certainly not giving up on his dream to top Google in online advertising, particularly in search.

"We have a talented team in place and a compelling plan to grow our business through innovative new services and strategic transactions with other business partners. While Yahoo would have accelerated our strategy, I am confident that we can continue to move forward toward our goals," Ballmer said in Saturday's statement.

"We are investing heavily in new tools and Web experiences, we have dramatically improved our search performance and advertiser satisfaction, and we will continue to build our scale through organic growth and partnerships," said Kevin Johnson, Microsoft president for platforms and services.