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And now Microsoft is talking with News Corp about combining forces on a joint-bid for Yahoo, with the aim of merging MySpace, Yahoo, and MSN (NYT).

All this news, of course, follows closely on the heels of Yahoo's first brilliant counter-move, which was to announce a test of a search partnership with Google.

Per the WSJ, here are the AOL-Yahoo details:

The possible Yahoo-AOL tie-up is part of a threefold plan by Yahoo to present shareholders with an alternative to Microsoft's unsolicited offer. Yahoo would also propose repurchasing billions of dollars of its own shares and is negotiating with Google Inc. about an advertising tie-up. On Wednesday, Yahoo announced a short-term test under which it will carry search advertising from Google.

Under the terms being discussed, Time Warner would fold its AOL unit into Yahoo and make a cash investment in return for about 20% of the combined entity, the people said. The deal, which wouldn't include AOL's dial-up access business, would value AOL at about $10 billion. As part of the deal, Yahoo would use the Time Warner cash and additional funds to buy back several billion dollars worth of its own stock at a price somewhere in the middle of the range between $30 and $40 a share, the people said. Any deal would be taken to Yahoo shareholders for approval, the people said.

As we've argued in the past, combining Yahoo- and AOL's assets makes sense (see below). Until recently, Time Warner's interest in a cash sale made the deal seem impossible, but recent speculation has been that Time Warner is now willing to swap AOL for equity in Yahoo.

A Google-Yahoo search partnership alone would not likely persuade Yahoo shareholders to forgo the Microsoft (MSFT) offer, but, as Rafat suggests, it is conceivable (conceivable) that a very well presented Yahoo-AOL merger combined with a Yahoo-Google search partnership might persuade shareholders to give the combo a chance for a while. At least until Microsoft comes back with a much sweeter bid (or a much lower one, if the deal bombs).

Also, AOL has no future as a standalone company, so it might as well merge with Yahoo or Microsoft now rather than later, in whole or in part. And there's certainly no reason for Time Warner to hang onto it. (AOL is one private nightmare that Jeff Bewkes would dearly love to end).

The big advantage of an AOL-Yahoo deal would be that it could happen relatively fast. (Though Microsoft would likely scream bloody murder and go rushing to the regulators). To make the deal successful, Yahoo's management would have to be absolutely ruthless about cutting costs and eliminating redundancy, bureaucracy, etc, and ruthlessness is not their strong suit.

But no matter what happens, after three years of feckless deterioration and two months of what seemed like bumbling post-bid denial, two big, aggressive moves from Yahoo in the space of a week would be a strong step toward redemption. If nothing else, Founder and CEO Jerry Yang would go down swinging.

Earlier: Brilliant Yahoo-Google Counter-Move Bolsters Demand for Higher Price

WHY YAHOO-AOL WOULD BE A SMART COMBINATION

As we argued several months before the Microsoft bid, a Yahoo-AOL combination would make sense for all parties--Yahoo, AOL, and Time Warner:

The combination would bolster Yahoo's domestic market position, especially in ad networks and display advertising. Yahoo and AOL have almost the same strategy with regard to owned-and-operated properties and third-party ad networks. By combining forces with AOL's Advertising.com, Tacoda, et al, Yahoo would dominate the third-party network business. It would also have far stronger owned-and-operated properties than AOL ever will as a standalone. The combination would allow the company to more effectively become a "must-buy" for advertisers, as well as a desperately desired alternative to Google.

The combined company would have a stronger share of search queries (which now might all be monetized by Google). Yahoo's search share has been declining, as has AOL's. It's true that tying two bricks together won't make them float, but neither will keeping them separate. More share is good, especially with search algorithm efficiency heavily dependent on volume. Google can make the search hay as long as it lasts, and the combined Yahoo-AOL can focus on display.

AOL's stand-alone brands--TMZ, Mapquest, Truveo, etc.--would fit will within the Yahoo empire and could be further leveraged though Yahoo's global distribution platform. .

AOL's AIM, ICQ, and Yahoo Messenger could all be standardized and made interoperable. This combination would make Yahoo by far the most powerful online communications platform, an area where Google is still weak.

Yahoo could replace AOL's ghastly email system with Yahoo Mail, bolstering Yahoo Mail's competitive position. This would save money and customers.

Yahoo could cut a lot of redundant cost (technology, data centers, distribution), which would make the AOL business far more profitable than it is today. The WSJ speaks of $1 billion in synergy. This could make the deal less expensive.

Yahoo could cut long-term distribution agreements with other Time Warner content properties, which would benefit both sides.

Economics

We estimate that AOL is worth about $10-$12 billion. Yahoo currently has about a $40 billion market cap (thanks to the Microsoft bid). Please see this online spreadsheet for details