(Updates with comments from Microsoft, U.S. Senator, Wall Street and legal analysts, plus details and bylines)
SAN FRANCISCO/NEW YORK, April 9 (Reuters) - Yahoo Inc (YHOO.O) said on Wednesday it will carry Web search advertising from Google Inc (GOOG.O) in a test that could put pressure on Microsoft Corp (MSFT.O) to raise its bid to buy the company.
Yahoo, facing a three-week deadline from Microsoft to reach a deal and eager for a higher offer, also is still in talks with Time Warner Inc's (TWX.N) AOL about a potential tie-up, a source familiar with the discussions said.
The two-week test with Web search leader Google would involve Yahoo targeting Google Web search advertisements at 3 percent of the users of Yahoo's own search services.
Microsoft fired back saying that a deal between Yahoo and Google would make the market for Web search less competitive -- turning the tables on Google, which has charged Microsoft with anti-competitive practices in the past. Microsoft would face tough scrutiny of its own from regulators if it buys Yahoo.
Microsoft General Counsel Brad Smith said Yahoo and Google would consolidate more than 90 percent of the search ad market in Google's hands. Herb Kohl, the Democratic head of the U.S. Senate antitrust subcommittee, chimed in to say he was watching Yahoo's deal closely to "ensure it does not harm competition."
Investors barely reacted to what was seen as Yahoo's latest effort to force Microsoft to raise its $42 billion bid. Yahoo shares rose 7 cents to close at $27.77, Microsoft gained 14 cents to $28.89, and Google fell 0.8 percent to $464.19.
Based on current stock prices, the value of Microsoft's proposed cash-and-stock bid for Yahoo is $42.1 billion.
"This doesn't put an end to the negotiations, but it perhaps balances things out," Cowen and Co analyst Jim Friedland said. "It looked like Microsoft had all the cards. Yahoo is at least now able to use this for leverage to get Microsoft to pay more."
A full-scale deal with Google would boost Yahoo's cash flow by reducing spending on rival technology and allow it to redirect staff and resources into its larger business selling corporate brand advertising such as banner ads, the analyst said. Yahoo could also step up its focus on areas where it leads such as online news, finance and sports, he said.
"A long-term deal could be the only option that allows Yahoo to remain an independent company," a source close to Google said.
Yahoo is not opposed to doing an eventual deal with Microsoft at a higher price, said a source familiar with Yahoo's thinking. A Google deal would represent a short-term measure to help the company shore up its own revenue.
Yet even if a Google deal happened, it would do nothing to stem the decline in numbers of Web searchers using Yahoo.
Yahoo's share of the U.S. Web search market has dropped more or less steadily to 21.6 percent in February from 26.9 percent in January 2007. Similarly, Microsoft's share is down to 9.6 percent in February from 10.4 percent in January 2007.
Meanwhile, Google's U.S. share has grown to 59.2 percent in February from 52.6 percent at the start of 2007, according to Internet audience statistics from comScore Inc.
Yahoo has traditionally led in graphical display ads, a more fragmented business. Google's share of display was relatively tiny until its acquisition last month of ad technology company DoubleClick Inc put it on a better footing.
Google derived almost all its $16.6 billion in revenue last year from small text ads alongside Web search results on its sites and affiliated partner sites such as AOL and Ask.com.
Google, plus AOL and Ask.com, represent 70 percent of the U.S. Web search audience, according to comScore. Were Yahoo to throw its search business to its competitor, Google's share of the U.S. Web search market would top 90 percent.
Since Google is better at turning search traffic into ad dollars than Yahoo and Microsoft, its actual share of revenue in this business is underestimated by search statistics.
Bruce McDonald, an antitrust partner at JonesDay, said combining Google and Yahoo in any significant way "would raise a lot of red flags. My gut reaction is that this is going to get a pretty intensive investigation," said McDonald, an ex-deputy assistant attorney general at the U.S. Justice Department.
Yahoo faces a three-week deadline issued by Microsoft Chief Executive Steve Ballmer in a letter to Yahoo on Saturday for Yahoo to agree to its offer or risk seeing the bid lowered and Microsoft starting a proxy battle to take over the board. (Additional reporting by Diane Bartz in Washington and Daisuke Wakabayashi in Seattle, editing by Richard Chang and Braden Reddall)