With Yahoo's planned advertising partnership with Google now in tatters, industry observers are left wondering what happened -- and what's next for the embattled Web pioneer.

The agreement would have seen Google sell ads against underperforming keywords on Yahoo's (NASDAQ: YHOO) search pages.

Yahoo struck the deal as it was seeking to reverse its slipping fortunes and facing intense pressure from shareholders frustrated with the stop-start acquisition talks with Microsoft. Hours after announcing that negotiations with Microsoft had formally ended, the Web portal had come forward with details about the Google deal, touting the partnership as a path to an additional $800 million in annual revenue.

Yesterday, however, Yahoo expressed dismay that its newest partner had also withdrawn its hand, bowing to the threat of legal action from federal antitrust authorities.

"Yahoo continues to believe in the benefits of the agreement and is disappointed that Google has elected to withdraw from the agreement rather than defend it in court," the company said in a statement.

Officials from the Department of Justice telephoned the companies yesterday morning and informed them that it planned to file an antitrust lawsuit to block the deal. Google (NASDAQ: GOOG) responded that it would terminate the agreement, and immediately notified Yahoo of its plan, according to a source familiar with the negotiations.

The DoJ had been reviewing the deal since it was signed in June, investigating the anticompetitive implications of an alliance between the top two companies in search advertising. The department hired a top antitrust litigator to shore up its case, and the companies twice delayed their planned implementation date.

Because they were not merging, the companies did not need formal approval to move ahead with the deal. However, they agreed to the voluntary delay to accommodate the review, which was joined by 15 states' attorneys general.

In its investigation, the DoJ determined that search advertising and search syndication are both relevant antitrust markets. Regulators worried that the tie-up would have led Yahoo to gradually cede its search business to Google as it became accustomed to the increased revenue from imported ads.

"The primary concern was that Yahoo would become almost overly reliant on Google's ads," the source told InternetNews.com.

Yahoo insisted that it would use the additional revenue to invest in its own search technology, and that it would continue to compete vigorously with its larger rival, but regulators were unconvinced.

"The arrangement likely would have denied consumers the benefits of competition -- lower prices, better service and greater innovation," Thomas Barnett, the assistant attorney general in charge of the DoJ's antitrust division, said in a statement.

Google and Yahoo had proposed modifications to the arrangement to make it more palatable to regulators, but ultimately they reached an impasse. After several iterations, they offered to cap the portion of Yahoo's search revenue that came from Google ads at 25 percent. They also proposed shortening the term of the agreement from 10 years to two, with no renewal clause, but neither of those two concessions satisfied the DoJ.

The agreement also had sparked fierce opposition from many advertisers who feared that the net effect would be higher prices and a less competitive market. Google cited this as a key reason for dropping out.

"After four months of review, including discussions of various possible changes to the agreement, it's clear that government regulators and some advertisers continue to have concerns about the agreement," David Drummond, Google's chief legal officer, wrote in a company blog post. "Pressing ahead risked not only a protracted legal battle but also damage to relationships with valued partners."

Moving on

In spite of its disappointment that the deal fell through, Yahoo said that it "was incremental to Yahoo's product roadmap and does not change Yahoo's commitment to innovation and growth in search."

Analysts are not so sure. Yesterday morning's news prompted JP Morgan's Imran Khan to reissue a note exploring the possibility of a sale of Yahoo's search business to Microsoft (NASDAQ: MSFT) -- a similar deal to the one that broke down in early June.

Khan believes that such a transaction would infuse Yahoo with an additional $725 million in annual operating cash flow, while making it a more "focused and nimble" company.

"Without its search business, Yahoo would be very clearly positioned as a content and display advertising entity, thereby clarifying and defining its purpose to advertisers and users," he wrote.

While Yahoo's revenues from search advertising continue to grow, Khan attributes most of that growth to improved monetization rates, which he does not believe are sustainable. He also notes that Yahoo's share of the search market has steadily declined as Google continues to grow.

Standard & Poor's analyst Scott Kessler similarly suggested that a tie-up with Microsoft remains more likely now that Google is out of the picture.

Last month, as it became clear that the government's objections to the Google-Yahoo deal were significant, rumors began circulating that Microsoft might be interested in renewing talks with Yahoo, prompting the software giant to issue this statement:

"Our position hasn't changed. Microsoft has no interest in acquiring Yahoo; there are no discussions between the companies."

Spokespeople for Microsoft and Yahoo did not immediately return phone calls and e-mails requesting comment.