Battle joined as Bill Gates prepares to take on the new kids on the block

Established giants such as Microsoft are having to work hard to keep the likes of Google at bay

Bill is running the company again. This was the assessment of one Wall Street veteran as Bill Gates's Microsoft promised to plough an extra $2bn (£1.1bn) this year into the development of software and services for the internet age. It was a strategic bombshell - which knocked $30bn off Microsoft's market value last week - and it threatens to trigger an arms race, as companies vie for dominance in some vast new markets.

Pretty much everything, from the software we use at work to the television we watch at home, could soon come to us via the worldwide web. While Mr Gates had been carving out a role as global philanthropist-in-chief, Google has come to dominate the search engine market, taken a lion's share of new online advertising revenues, and threatens to move into all sorts of other areas that Microsoft currently feels it owns by right.

Mr Gates's message to Google: oh no you don't.

In the latest spat between the two companies, Google has asked competition regulators to investigate Microsoft's newest version of its web browser, Internet Explorer. The software encourages users to search the internet using Microsoft's MSN search engine, Google claims, rather than making it just as easy to use rivals including, of course, the ubiquitous Google.

Microsoft, for its part, says it is easy to add short-cuts to Google and any other search facilities. But it is making no secret of its desire to claw back some internet traffic. A brainstorming session with partner companies this week is majoring on how to win a greater share of online advertising revenue for MSN.

Stung by the stock market reaction to its earnings guidance last week, which sent the shares down 11 per cent in its worst one-day performance for five years, the company has been trying to explain itself more clearly to Wall Street over the past few days.

Key to this was the judicious leak of an internal memo to employees by the Microsoft chief executive, and number two to Mr Gates, Steve Ballmer.

In it, he says: "Further development of adCenter is key - our goal is to create the web's largest advertising network, giving us an engine that will enable us to monetize our services and compete against Google ... These are long-term efforts and we may not see results overnight. But we are making smart investments that will enable us to win in this vital area."

Analysts believe that perhaps up to half the extra investment will be channelled to MSN - Microsoft's consumer internet brand, which groups together its search engine, its Messenger instant-messaging service and Hotmail email, along with news and entertainment content. As well as developing the software and the look of the site, the company is also having to invest in the servers that house all that content. Microsoft has just bought a 75-acre site in its native Washington state to build a "server farm" for thousands of computers.

Jason Maynard, a technology analyst at Credit Suisse, said: "Perhaps an explanation could be that Microsoft is spending enough money to build a Google-sized business inside their company."

It remains an open question just what MSN might look like by the end of the decade. Will it be a community site, overtaking or living in the shadow of MySpace? Will it be a centre for music and TV on the net, driving traditional broadcasters out of business or doing deals with them? The only thing sure at this point is that it will drain Microsoft's profits next year.

There is a growing band of analysts that has become alarmed at rising costs inside the giant technology companies, and alarmed further by managements' unwillingness to explain how the cash will make a return. Amazon.com and Google have also been hiking spending on unspecified technological upgrades and new services. Cynics keep making references to 1999, the last time technology investment boomed and a date with all the portents of a bust just around the corner.

There are vast opportunities. Microsoft has developed software that allows TV to be piped into the home via the internet, and nine major internet service providers are testing new so-called IPTV services. This is the sort of service that could upend the business models of traditional pay-TV companies such as BSkyB. Also, the admittedly heavy investment in getting shipments of the new Xbox ready will surely mean it can take a commanding early lead over the Sony's delayed PlayStation 3 come Christmas, and the ability to place ads inside web-based computer games could be a lucrative new source of revenue.

Wall Street had hoped that with the launch of the Xbox 360 and of new versions of the Windows operating system and Office suite of basic business software programs next year, Microsoft could just sit back and count the money rolling in. It seems, though, that it has little choice but to make significant investments even in the core software business.

Credit Suisse's Mr Maynard said: "It is clear to is that the company is facing its most strategic inflection point in nearly 10 years, as internet services stand ready to displace PC-centric computing."

Alarmingly, Google and others have started to offer free software over the web, most notably calendar tools funded by the placement of adverts. Google just purchased Writely, a web-based word processor, and has done its first deal with Dell, the PC manufacturer, to pre-install its software on to new machines.

So Microsoft is experimenting with Windows Live and Office Live, and considering selling its software by subscription over the net. Mr Ballmer's memo talks of the need to make "big, bold bets" across an array of businesses under the Live banner.

Kash Rangan, an analyst at Merrill Lynch, wrote in a note to clients: "Windows Live and Office Live are the experimental steps with an advertising-based model but the core business is still selling shrink-wrapped software. Google's recent forays into the desktop are probably raising considerations whether Microsoft should remake its core business model into subscriptions. The more tightly you weave the Internet into Vista and Office, the more that prompts questions whether the core business is a service or a product. It requires some tough compromises with Wall Street."