Google is the sleeping giant when it comes to advertising in video games. While the company dominates search advertising, it has yet to make a big splash in video games. That could change soon, as the company has been quietly testing its “AdSense for Games” product for months.

Sources close to the matter said that the company has developed an in-game advertising technology that allows it to insert video ads into games. In demos of the technology, a game character can introduce a video ad, saying something like, “And now, a word from our sponsor,” before showing a short video at the end of a sequence in a game. Since testing has been going on for some time, Google could launch the technology fairly quickly, if it so chooses.

But it’s not clear why Google hasn’t already launched its in-game advertising business, given that the seeds of AdSense for Games were planted in early 2007. Google did not respond to a request for comment this morning. I’ll update if that changes.

“I don’t know what’s taking them so long,” said one source close to the matter. “They could move into this market very quickly, given what they have shown off.”

If the company enters the market, it should stir up the competition the way it has in other ad markets. Companies such as Double Fusion, IGA Worldwide, Microsoft’s Massive, MochiMedia and NeoEdge Networks have been carving out niches with in-game or wrap-around ads for some time.

All of the companies know the potential of the market. Advertisers are turning to in-game ads because it’s one of the only ways to reach young male gamers who have stopped watching TV. The Yankee Group predicts the market will be worth $971.3 million by 2011. Google’s top executives know that search advertising may not last forever, and in-game advertising could become a compelling technology over time as both games and in-game ad technology become more and more engaging. Google would cover its bases by making a small side bet on in-game ads.

Google’s technology can be applied to console games, disk-based PC games, web-based PC games and cell phone games. But those who are kicking the tires on the technology (outside the company) have not seen all of those platforms in action.

One of its options is to keep testing its technology while it waits for the market to get bigger. The company drew attention to its game-ad intentions when it bought Adscape for $23 milion in February, 2007. Bernie Stolar, the former head of both Sega of America and Sony Computer Entertainment America, was Adscape’s chairman. Working for Google, he gave a speech just about a year ago describing “AdSense for Games” at the 2007 Casual Connect conference in Seattle. In the talk, Stolar said Google had no plans to make games or otherwise enter the game portal business; Google just wanted to do ads.

A flurry of stories appeared in November last year that Google was launching its beta test with Bunchball. That involved only pre-roll advertising, not with in-game characters. The Bunchball Facebook games rolled out with the Google ads, but not much else happened. That false move is a reason why some of the partners are wondering if Google is really going to go forward or not.

In buying Adscape, Google was reacting to Microsoft’s own move into in-game advertising. In May 2006, Microsoft bought Massive, the pioneer of in-game ad networks that was founded in 2004. Since the acquisition, the market gathered steam. Alison Lange Engel, global marketing director for Massive, said that the company now has more than 200 advertisers in its network. Those companies can insert either fixed or live ads into games. The live ads are more suitable for short-term campaigns because the companies can change the ads on the fly, using Internet connections to pipe new content into video game consoles. More than 70 games now use Massive’s in-game ads.

The battle lines have been drawn. Yahoo, which draws 18 million gamers a month to its Yahoo Games portal in the U.S., recently signed up NeoEdge and Double Fusion as its in-game ad partners. Electronic Arts has a variety of partners. And Sony has signed up Double Fusion and IGA Worldwide. Sony is thought to be a prime potential customer since it is launching its Home virtual world for gamers in the fall on its PlayStation Network for the PlayStation 3. Among the console makers, only Nintendo has been quiet when it comes to in-game ads. At this rate, there may not be much left for Google. It better not wait too long.

The insider buzz is growing about Google’s plans, particularly since its big sales force could generate a lot of interest in the ad platform. A bunch of Google representatives attended the 2008 Casual Connect show in Seattle last week, but they didn’t answer questions about when Google would jump into the in-game ad market.

Google spilled part of its intentions by announcing its virtual world — or more appropriately virtual room. The company launched Lively by Google earlier this month. Lively by Google would be a natural vehicle for Google’s AdSense for Games product, which could insert ads into the rooms of users. In fact, others expect it to be a proving ground.