Nov. 5 (Bloomberg) -- Google Inc., the top seller of online advertising, scrapped an agreement to place ads on Yahoo! Inc.'s site after the U.S. government threatened to challenge the venture.

The Justice Department said today it would have sued to stop the alliance. Yahoo rose 4.3 percent after the announcement. Regulators and advertisers' concerns about the deal may have hurt Google's long-term interests, David Drummond, the company's chief legal officer, said today in a blog post.

The action is the first significant time that Google has backed away from an attempt to expand its reach, said Rebecca Arbogast, an analyst at Stifel Nicolaus & Co. in Washington. While abandoning the deal helps Google avoid a confrontation with the government, concerns that it has become too strong won't disappear, she said.

``What they avoid by walking away from this is any adverse legal precedent at all,'' Arbogast said. ``They will be completely unsullied.''

Microsoft Corp., which trails Google and Yahoo in online ads, also had criticized the agreement, saying it would give Google too much power. The company fielded about two-thirds of U.S. searches last year, three times the amount of second-place Yahoo. The U.S. online ad market may rise 17 percent to $26.2 billion this year, according to EMarketer Inc.

Mountain View, California-based Google fell $24.70, or 6.7 percent, to $342.24 at 4 p.m. in Nasdaq Stock Market trading. Sunnyvale, California-based Yahoo climbed 57 cents to $13.92.

Google Not Distracted

``We're not going to let the prospect of a lengthy legal battle distract us from our core mission,'' Drummond said in the blog posting. ``That would be like trying to drive down the road of innovation with the parking brake on.''

The end of the deal and the settlement last week of a legal battle with publishers over online book searches indicate Google wants to improve its image in Washington, said Colin Gillis, managing partner of Click Capital Research.

``It follows a trend by Google as a company to reduce any exposure or sentiment of it not being a solid corporate citizen,'' New York-based Gillis said.

The decision leaves Yahoo, which turned down takeover offers of as much as $47.5 billion from Microsoft this year, without a new source of ad sales. Yahoo estimated that the deal would generate as much as $450 million a year in operating cash flow in its first year.

To allay regulatory concern, Google and Yahoo proposed revisions that would have cut the deal's length to two years from 10, people familiar with the matter said last week. The changes also would have limited the amount of revenue Yahoo could get from the pact to 25 percent of its total Web search sales.

Yahoo Disappointed

Yahoo said it's disappointed by Google's decision to withdraw from the deal rather than defend it against the Justice Department. Nevertheless, the agreement was ``incremental'' to its products, the company said.

Yahoo's stock had dropped 49 percent since Microsoft halted takeover attempts. Jeff Lindsay, a Sanford C. Bernstein & Co. analyst in New York, predicted that Microsoft may bid $20 a share for Yahoo next year.

``The Department of Justice's finding is significant for advertisers, publishers and consumers, who voiced overwhelming concern about this illegal deal,'' Brad Smith, Microsoft's general counsel, said in a statement.

Frank Shaw, a spokesman for Redmond, Washington-based Microsoft, declined to comment on whether his company would renew overtures to Yahoo.

Stock Performance

Yahoo's gain today suggests investors view the end of the Google pact as an opportunity for Microsoft to make another offer for Yahoo's search business, said Youssef Squali, an analyst at Jefferies & Co. in New York.

``I think Microsoft wants it more than it's letting on,'' said the analyst, who recommends buying Yahoo and Google shares. ``It needs it if they want to be relevant in the search world against Google.''

Google's share of online searches has helped it command higher prices and draw a wider variety of advertisers, Yahoo has said. Chief Executive Officer Jerry Yang aimed to use Google ads for so-called keyword searches.

``The agreement between these two companies accounting for 90 percent or more of the relevant market would likely harm competition,'' the Justice Department said today in an e-mailed statement. ``Google and Yahoo would have become collaborators rather than competitors.''

Takeover History

The companies announced their agreement after Yahoo rejected attempts by Microsoft to buy the company, or at least its online search business. Microsoft, which accounted for 8.5 percent of online queries in September, wanted to use Yahoo to help catch up with Google.

The Justice Department hired attorney Sanford Litvack as an adviser in September, signaling that the government was looking into an antitrust challenge. Litvack, the department's antitrust chief under President Jimmy Carter, headed a 2006 commission created by Congress to consider changes to antitrust law.

The Association of National Advertisers, a trade group, opposed the Google-Yahoo deal, saying it would push ad prices higher. The American Antitrust Institute, a Washington advocacy group, called for restrictions to limit Google's control of the market.

On Sept. 29, a group of U.S. lawmakers from California urged the government not to block the deal, saying Google wouldn't gain power because the agreement wasn't a merger.

Earnings Performance

With profits falling and revenue growth stalling, it may be too late now for Yang to seek another offer from Microsoft, Arbogast said. While Microsoft CEO Steve Ballmer has suggested that a deal with Yahoo might still make economic sense, the company said Oct. 16 it has no interest in an acquisition.

Yang, 39, still plans to speak today at the Web 2.0 Summit, a conference in San Francisco, said Brad Williams, a Yahoo spokesman. Yang is scheduled to appear at 4:50 p.m. local time.

Yahoo's profit has dropped in 10 of the past 11 quarters, and net sales growth slowed to 3 percent last quarter, down from 14 percent a year earlier. In August, investors withheld about a third of their votes for Yang's re-election to the board in a demonstration of their displeasure. The executive will celebrate his 40th birthday tomorrow.

Yahoo has also talked with Time Warner Inc. since April about an acquisition of that company's AOL business. Yahoo executives said on an Oct. 21 conference call that they were socking away cash as they weighed their options.

``We can't really and don't speculate on any potential deals,'' Time Warner CEO Jeff Bewkes said today on a conference call. ``We have said that if there was a strategic opportunity to put AOL in a stronger position, we would look at it closely.''

To contact the reporter on this story: Crayton Harrison in Dallas at tharrison5@bloomberg.net

Last Updated: November 5, 2008 16:13 EST