Time Warner’s board gave its blessing to a strengthened alliance between its AOL unit and search engine Google on Tuesday in a move that is likely to change the way online advertising is sold by these Internet powerbrokers and viewed by their consumers.

Under the terms of deal, Mountain View, California-based Google is paying $1 billion for a 5 percent stake in AOL, which remains one of the web’s most visited sites despite declining subscriber numbers.

Expected for some time, Google’s move cements its relationship with one of its biggest customers. AOL accounted for 8 percent of Google’s $1.6-billion gross revenue for the period ended September 2005.

As for AOL, it will now be able to sell search advertising directly to advertisers on its own properties using Google’s technology. Before the deal, Google controlled the advertising on AOL as the ads on the portal appear whenever users perform searches using Google’s technology.

Among other elements of the expanded partnership, the two will also run a greater number of display ads. These larger banner-type ads have to date not often been featured on Google, which is known for its sparse interface.

The broadened alliance between the two companies, however, is likely to further stir the passions of Carl Icahn, an activist Time Warner shareholder. Mr. Icahn on Monday warned the deal could be “disastrous” because it might preclude a more profitable option for AOL, such as an outright sale to other companies (see Icahn Attacks AOL-Google Deal).

Whether that is true, the transaction is sure to create new hurdles for competitors like Microsoft, which reportedly had been also eyeing a stake in AOL.

For Time Warner itself, the deal means much more than a cash infusion. It’s a shot at boosting ad revenue that could offset the decline in revenue from AOL’s eroding subscriber base.

Thwarting a Threat

For Google, it means victory. After months of negotiations, it has succeeded in thwarting a threat by Microsoft, which is presently testing its paid search offering.

The Redmond-based software behemoth has been striving to make its presence felt in the Internet search and services business. Its executives have often said that this is the industry that will fuel the company’s future growth. But Google isn’t going to step aside and bequeath the throne just yet.

The deal ensures that AOL will use Google’s search technology for five years after the original agreement ends in 2006. But it comes with a hefty price.

Not only will Google promote AOL’s sites in the sponsored links in its search results, but AOL will receive $300 million worth of advertising, sources within AOL said.

This is a win for Google, as well as for Time Warner, which retains a majority stake in AOL. But it also is a win of sorts for Yahoo. Even though Sunnyvale, California-based Yahoo didn't get a piece of AOL, the deal prevents Microsoft from increasing its scale in search, said Goldman Sachs analyst Anthony Noto in a research note (see Yahoo Denies It Bid for AOL). And that of course, helps all the other search companies in the space.

“The negatives here are that Google has likely had to make a sizeable cash commitment to maintain the AOL partnership, and the search advertising extension may be on terms less favorable than before,” Mark Mahaney, an analyst with Citigroup, wrote in a research note. “The compensating positives are that Google appears to have secured AOL versus a competing offer from Microsoft— maintaining part of its scale advantage in the sector—and the new partnership may give Google greater inroads into display advertising.”

According to the terms of the deal, which was approved by Time Warner’s board after the markets closed, the two companies will also collaborate on an online video offering. Google will also direct its users to AOL content, and allow users of its instant messaging software, Google Talk, to communicate with users of AIM, AOL’s instant messaging product.

Time Warner's stock rose $0.10 to $17.84 in after-hours trading. Google rose $1.16 to $430.90.

Co-branded Ads

The Google economy has been built around search advertising in the margins of its pages. But this deal will require the company to sell display ads—the larger type of ads commonly found on most commercial sites.

That may be a jarring experience for consumers, who have proven willing to accept the less-intrusive search ads in exchange for the free service. But it may have little effect.

“They’re locking in AOL eyeballs, but will not do anything to jeopardize Google eyeballs. I don’t think we’ll see any dramatic changes,” said Kevin Lee, the chief executive of Did-It, a search engine marketing firm. “You won’t see revolutionary changes, but will see evolutionary changes.”

In 2005, display advertising generated $5.1 billion while search advertising revenue amounted to $4.2 billion, according to JupiterResearch. Both are rapidly growing components of the online advertising business. By 2010, display advertising is supposed to hit $7.18 billion and search $7.5 billion.

Mr. Lee said he expected Google would use AOL’s content to maintain its relevance in advertising. “If someone searches for Billy Joel, they probably want music and video-enhanced ads,” he said. “AOL has a lot of great content, especially when you fold in Time Warner.”

But it isn’t likely that Google will favor AOL as it pulls up its organic search queries, he said. As it does with its other customers, it will give the Internet company a tutorial in what it could do to come up higher in the search result listings. But that’s about it.

Search Locked Up

Google is the market leader in search, accounting for more than a third of all U.S. searches, according to comScore Media Metrix. AOL accounts for nearly 10 percent. After this deal, Time Warner isn’t likely to strike a search-related deal with any of the competitors, such as Yahoo and IAC/Interactive’s Ask Jeeves.

“If you look at the size of the transaction, it’s only 5 percent—Time Warner will have the ability to sell a piece of AOL,” said Tom Forte, an analyst with Geneva Investment Management of Chicago. “But on the search front, this would tie the two together. I have a hard time believing Time Warner would use Microsoft’s search technology for another part of the company.”

This is a win for Google, as well as for Time Warner, which retains a majority stake in AOL. But it also is a win of sorts for Yahoo. Even though Sunnyvale, California-based Yahoo didn't get a piece of AOL, the deal prevents Microsoft from increasing its scale in search, said Goldman Sachs analyst Anthony Noto in a research note (see Yahoo Denies It Bid for AOL). And that of course, helps all the other search companies in the space.