Instead of a buyout, as originally planned by Microsoft, the two will enter into a revenue sharing agreement. It is expected to be announced officially today (29 July 2009).
Former Yahoo chief executive Jerry Yang rejected a buyout offer from Microsoft at $33 a share - $47.5bn in total - in February 2008.
The partnership deal comes after months of intermittent talks about joining forces in the online advertising market to challenge Google.
Under the expected deal, Microsoft's recently-launched Bing search engine will drive Yahoo's searches, according to Advertising Age. Yahoo will handle advertising sales using Microsoft technology.
The partnership is expected to step up Microsoft's bid to increase its 8.4% share of the search market dominated by Google.
By adding Yahoo's 19.6% share, the deal will boost Bing's share to nearly 30% against Google 65% share.
Shares of both companies increased slightly in after-hours trade. Yahoo's share price increased $0.17 to $17.39 and Microsoft shares climbed $0.04 to $23.47.
Advertisers are also expected to welcome the deal because it will foster competition by creating a second strong search company.
The deal still faces approval by US anti-trust regulators who blocked an advertising partnership between Yahoo and Google last year.
Microsoft was among those opposed to the deal on the grounds that a Google partnership with Yahoo would threaten to limit the web ad market for advertisers.