SAN FRANCISCO (MarketWatch) -- The battle between Yahoo Inc. and Microsoft Corp. has escalated by several notches amid a flurry of reports that has the Web portal working with rivals Google Inc. and AOL in an attempt to put together a deal that would thwart the software giant's unsolicited takeover offer.

Not to be outdone, Microsoft MSFT, -1.04% is reportedly in its own talks with media giant News Corp. to put together a potential joint bid for Yahoo YHOO.

Against this backdrop, Yahoo shares rose more than 2% to about $28.40 at the opening bell on Thursday. Microsoft's stock rose a fraction to about $29.

The action comes just days after Microsoft CEO Steve Ballmer tried to jump-start the stalled process by sending a letter to Yahoo's board -- setting a three-week deadline to close the deal and threatening a proxy battle if the offer was rejected. See full story

It's been 10 weeks since Microsoft announced its offer to buy Yahoo for $31 per share in a mix of cash and stock. Yahoo rejected the offer as undervaluing its business, and since then, the value of the deal has fallen from its original level of about $44.6 billion to around $39 billion, based on Microsoft's share price.

Yahoo has since raced to put together alternatives to the Microsoft proposal. Wednesday, the company announced it will begin a test program with arch-rival Google GOOG, +0.32% , under which it will use Google's search-advertising service to deliver ads through related searches done on Yahoo's Web site.

Yahoo said the test will last up to two weeks, involve traffic only on its site in the U.S. and relate to no more than 3% of its search queries. See full story

The company added that the test "does not necessarily mean that the company plans to join Google's AdSense for Search program or that any further commercial relationship with Google will result," adding that it will not comment on "the nature or timing of any potential relationship."

Citigroup analysts Mark Mahaney and Brent Thill called the test with Google "an aggressive response" to the threat of a proxy battle from Microsoft.

"As such, we believe this will increase pressure on Microsoft to increase its $31 offer price," the analysts wrote in a note to clients. "Arguably, a worst-case scenario for Microsoft would be a full Google search outsource decision by Yahoo."

AOL rumors re-emerge

Meanwhile, The Wall Street Journal reported that Yahoo was also in talks with the AOL unit of Time-Warner Inc. TWX, .

Rumors of talks between the Web brands were floated several weeks ago, but no deal has emerged. According to the Journal, Time-Warner is considering a move to fold AOL into Yahoo and make a cash investment of an unspecified amount for a 20% stake in the combined entity. The deal would value AOL at about $10 billion.

The cash would allow Yahoo to buy back a large portion of its own stock, paying between $30 to $40 a share. The report cited unnamed sources "close to the talks" who added there was still "a lot of work to do" before ironing out an agreement. See Wall Street Journal story. (Subscription required)

A deal among Yahoo, Google and AOL would potentially face scrutiny from regulators, since Google already controls about two-thirds of the search-ad market.

Following Yahoo's announcement of the test with Google, U.S. Sen. Herb Kohl, D-Wis., chairman of the Senate Judiciary Committee's Subcommittee on Antitrust, Competition Policy and Consumer Rights, said his subcommittee will be "following closely the results" of the test.

"Should there be moves to make this agreement permanent, we will examine it closely in the antitrust subcommittee to ensure that it does not harm competition," Kohl said in a statement.

The move promptly drew a response from Microsoft, which blasted any proposed alliance between Yahoo and Google in the search market as potentially anticompetitive. Microsoft General Counsel Brad Smith said the agreement "would consolidate over 90% of the search advertising market in Google's hands."

"This would make the market far less competitive, in sharp contrast to our own proposal to acquire Yahoo," Smith said in a written statement. "We will assess closely all of our options. Our proposal remains the only alternative put forward that offers Yahoo shareholders full and fair value for their shares."

News Corp. back at the table?

Another potential player in the affair is News Corp. NWS, -3.57% NWS. The Journal story said Microsoft was in talks with the media giant over a potential joint-bid for Yahoo, but gave no further details.

Another report in the New York Times said the companies were talking over a joint bid that would create an Internet behemoth that would combine Yahoo with Microsoft's MSN service and the popular MySpace social networking hub owned by News Corp.

The Times said talks between Microsoft and News Corp. "are at a sensitive stage," citing unnamed sources. An alliance between the companies could remove a potential ally for Yahoo; News Corp. was said to be in earlier talks with the Web portal, but no deal emerged from those discussions.

News Corp. owns MarketWatch, publisher of this report, as well as the Journal.