Microsoft has scrapped plans to buy Yahoo after failing to reach agreement on a price and as the struggling internet firm threatened to forge closer links with Google to repel the unwanted takeover.

In discussions last week, the software giant increased its bid to $33 per share, adding $5bn to the $42bn offer it made on 31 January – a 70 per cent premium on the stock value at that time. But Yahoo was holding out for at least $37 per share – a figure that Microsoft was unwilling to pay, according to chief executive Steve Ballmer.

“Despite our best efforts, including raising our bid by roughly $5bn, Yahoo has not moved toward accepting our offer. After careful consideration, we believe the economics demanded by Yahoo do not make sense for us, and it is in the best interests of Microsoft stockholders, employees and other stakeholders to withdraw our proposal,” he said.

In a letter to Yahoo chief executive Jerry Yang published on Microsoft's web site, Ballmer also said that his firm will not pursue its alternative strategy of trying to replace the board of the search provider in a proxy contest because of Yang's intention to make an acquisition “undesirable” by working more closely with key rival Google.

Ballmer revealed that Yahoo had threatened to outsource parts of its paid internet search function to Google – the two companies are already conducting a small-scale trial of such an arrangement.

“This would also effectively enable Google to set the prices for key search terms on both their and your search platforms and, in the process, raise prices charged to advertisers on Yahoo,” said Ballmer.

“In addition to whatever resulting legal problems, this seems unwise from a business perspective unless in fact one simply wishes to use this as a vehicle to exit the paid search business in favour of Google.”

Yang said Yahoo can now look ahead and proceed with its strategic plans.

“With the distraction of Microsoft's unsolicited proposal now behind us, we will be able to focus all of our energies on executing the most important transition in our history so that we can maximise our potential to the benefit of our shareholders, employees, partners and users,” he said.

During the period of Microsoft's offer, Yahoo sought partnerships with a variety of other companies in an attempt to prevent a takeover, including Rupert Murdoch's News Corp, Time Warner/AOL and Google. It remains unclear whether or not Yahoo will pursue any of these options now that Microsoft has withdrawn its bid.