Google has scrapped its internet advertising partnership with struggling rival Yahoo, abandoning attempts to overcome the objections of anti-trust regulators and customers who believed the alliance would give Google too much power over online commerce.

The retreat announced today represented another setback for Yahoo, which had been counting on the Google deal to boost its annual revenue by $800m (£496m) and placate shareholders still incensed by management's decision to reject a $47.5bn takeover bid from Microsoft six months ago.

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Google backed off after the US Justice Department said it would sue to block the Yahoo deal to preserve competition in the internet's rapidly growing advertising market.

"The arrangement likely would have denied consumers the benefits of competition — lower prices, better service and greater innovation," said Thomas Barnett, an assistant attorney general who oversees the Justice Department's anti-trust division.

Without Google's help, Yahoo now may feel more pressure to renew talks with Microsoft and ultimately sell for a price well below the $33 per share that Microsoft offered in May. Yahoo shares traded this morning at just $14.05, gaining 70 cents in a move reflecting investor hopes that Microsoft might renew its pursuit.

Surrendering the chance to sell ads on Yahoo's popular website won't be a significant financial blow for Google, which already runs the internet's largest and most prosperous advertising network.

But the capitulation marks a rare comedown for Google, which had been insisting for more than four months that the internet would be a better place to do business if it were allowed to work with Yahoo.

"We're of course disappointed that this deal won't be moving ahead," David Drummond, Google's chief legal officer, wrote on a company blog. "But we're not going to let the prospect of a lengthy legal battle distract us from our core mission. That would be like trying to drive down the road of innovation with the parking brake on."

Yahoo said it wanted to fight the Justice Department in court, but played down the impact Google's retreat would have on its turnaround efforts.

"This deal was incremental to Yahoo's product roadmap and does not change Yahoo's commitment to innovation and growth in search," the company said in a statement. "The fundamental building blocks of a stronger Yahoo...were put in place independent of the agreement."

Google's management took a strategic risk by agreeing to the Yahoo partnership in June, knowing the move would increase the government's scrutiny of Google's market power. Even though it is now walking away empty-handed, Google figures to remain in regulators' sights as it tries to expand.

"For the first time, Google has run into real opposition to its marketplace goals," said Jeff Chester, executive director of the Center for Digital Democracy, a consumer advocacy group. "Google is aware that its aggressive moves in the online advertising business are potentially contributing to damaging its brand. The perception of Google has changed."

The collapse of the Google-Yahoo alliance shapes up as a potential coup for Microsoft.

Although it has publicly said it's no longer interested in buying Yahoo, Microsoft spent a lot of time and money trying to keep Google and Yahoo from coming together.

The world's largest software maker provided evidence that helped persuade regulators the partnership would diminish competition. Microsoft also helped orchestrate the campaign that prompted major advertisers to lodge formal complaints against the proposed partnership.

The Justice Department signalled it was considering a legal challenge to the deal in September when it hired veteran antitrust lawyer Sanford Litvack to review the case.

The Wall Street Journal reported on Monday that Google and Yahoo had proposed restrictions on the deal — capping the amount of search ads Yahoo could outsource to Google — in a late bid to win favour. Google's statement today indicated the idea was not successful.

"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," Drummond wrote. "Pressing ahead risked not only a protracted legal battle but also damage to relationships with valued partners. That wouldn't have been in the long term interests of Google or our users, so we have decided to end the agreement."

Now that Google is out of the picture, Yahoo co-founder Jerry Yang will have to come up with another way to accelerate his company's revenue growth and boost a stock price that has lost more than half its value since he became chief executive in June 2007.

If nothing else, Yang appears to have a bigger incentive to join forces with another tarnished internet star, AOL. Yahoo has been discussing a possible acquisition with AOL's corporate parent, Time Warner, for months. Google also owns a 5 percent stake in AOL.

But many Yahoo shareholders, including new board member Carl Icahn, have indicated they think the Sunnyvale, California-based company should try to lure Microsoft back to the negotiating table.

Most industry analysts still believe Microsoft will make another run at Yahoo, particularly now that the company can be bought at a fraction of the May offer. Instead of buying Yahoo in its entirety, Microsoft might just want Yahoo's search engine, which ranks a distant second in usage behind Google's. Microsoft attempted to buy Yahoo's search engine shortly before the Google partnership was reached.

Under the terms of the proposed partnership, Yahoo would have drawn on Google's superior technology for some of the ads shown alongside the search results on its website. Yahoo would have pocketed most of the revenue generated from Google's ads.

The concept didn't pan out because Google and Yahoo combined control more than 80 per cent of the US search advertising market. Microsoft and the Association of National Advertisers, among others, argued the arrangement would enable Google to gradually increase advertising prices and exert more control over the flow of e-commerce.

Google and Yahoo said the complaints were misguided because search advertising rates are set through an auction-style system. What's more, the partnership was supposed to be non-exclusive, leaving an opening for Microsoft and others to vie to sell ads on Yahoo's website.

But helping out Yahoo began to make less sense for Google as it became apparent how much the proposal was alienating the government and advertisers.