Microsoft -- rebuffed this year in efforts to buy all of Yahoo and then just its search business -- is talking about alternative deals with Time Warner Inc, which owns AOL, and News Corp, parent of MySpace, a source close to Microsoft said, but any negotiations remain in preliminary stages.

Meanwhile, talks have continued for months between Yahoo and Time Warner over a potential merger of AOL with Yahoo to create a more formidable advertising and media player, but they are no closer to a deal, a source close to the matter said.

Shares of Yahoo jumped as much as 9 per cent on Wednesday after the Wall Street Journal reported that Microsoft, positioning for a new run for Yahoo's search business, had in recent days approached media companies to join together on a deal that would effectively lead to Yahoo's breakup.

The Wall Street Journal also said Microsoft met with activist investor Carl Icahn in recent days to encourage him to press his proxy battle for control of Yahoo's board, the first sign Microsoft welcomed his month-old campaign. This development also was attributed to unnamed sources familiar with the talks.

Icahn was not available to comment on the report.

Microsoft, Yahoo, Time Warner and News Corp all declined comment.

REVIVING HOPE

Wall Street analysts said the latest news revived flagging hopes among some investors that Microsoft was still interested in doing a deal with Yahoo. "The hopes that Microsoft would come back were getting crushed over the last 10 trading days," Collins Stewart analyst Sandeep Aggarwal said.

Yahoo stock ended the day up 3.4 per cent at $20.88. The stock had traded as low as $19.58 on Tuesday, near its level in late January before Microsoft made its unsolicited takeover bid for Yahoo, sending the stock above $30 by mid-February.

Microsoft shares fell 3.7 per cent to $25.88 on Wednesday. In the prior day's trading, Microsoft fell to two-year lows of $23.19, intraday, before recovering.

Analyst Youssef Squali of Jefferies & Co said the sharp Yahoo stock reaction was most likely a defensive move by short-sellers seeking to cover bets a Microsoft deal was off.

"Even the rumor that Microsoft is getting interested again is enough to have people to want to cover their bets against Yahoo stock," Squali said, adding that many investors have shorted Yahoo from the high $20s all the way down below $20.

Adding to the volatility were options investors who placed fresh bets Yahoo would be trading up to $27.50 by October, said analyst Rebecca Engmann Darst of Interactive Brokers Group.

THE WAITING GAME

Several financial analysts said a key detail in the Journal report was that Microsoft and Yahoo executives had sought to revisit the merger on May 17 -- two weeks after Microsoft walked away -- and that two Yahoo board members in the meeting had said they would settle for a merger worth $33-$34 a share.

On May 3, Yahoo rejected a $33-a-share Microsoft offer worth $47.5 billion, and earlier this week questioned whether the software maker was ever serious about a full-scale merger.

The source familiar with Microsoft's thinking confirmed that Yahoo had belatedly sought a deal in mid-May worth $33 to $34, but that Microsoft was no longer interested at that point.

The source said Microsoft executives considered the early May deadline as vital to winning regulatory approval before the end of the year -- when a new presidential administration arrives and months more delays would likely occur.

Microsoft also become convinced that Yahoo executives were passively resisting the deal and unwilling to seriously negotiate. Meanwhile, the economy has taken a toll on the online ad market, and with it, the value of buying Yahoo.

"Microsoft is going to let Icahn do the dirty work and hand Yahoo over to them," Jefferies & Co's Squali said, adding that it was in Microsoft's interest to hang back and let Yahoo shares settle lower as investors quit betting on a takeover premium.

In the long run, however, Microsoft needs Yahoo more than Yahoo needs Microsoft, he argued.

"Microsoft has a gaping hole in its strategy and it's called the Internet and it's only getting worse because Google is encroaching on Microsoft's business," Squali said.

Separately, the US Justice Department is pursuing a formal antitrust investigation into a deal reached last month between Yahoo and Microsoft-archrival Google Inc to team up on Web search advertising.

Google, with more than 60 per cent of the Web search market, and Yahoo, with 16.6 per cent, agreed to a deal for Google to run search ads on Yahoo's site in a partnership that could mean $250 million to $450 million in new cash flow for Yahoo.