Windows Live is being hived off into its Windows division, while its ad and media assets such as aQuantive, ad-serving, search and MSN are moving into a separate, new online services division.
The changes come as Microsoft's head of Microsoft's Platforms and Services Business, Kevin Johnson, is leaving to join Juniper Networks.
Johnson is a 16-year Microsoft veteran and one of three divisional presidents under chief executive Steve Ballmer.
The new groups will now both report directly to Ballmer.
According to reports in the US, citing sources close to Ballmer, the decision was driven by Ballmer's desire to split the divisions, and by Johnson's desire to be a chief executive.
Observers questioned the move to split its online assets - pointing out that online competitors such as Google and Yahoo operate from within the same platform - arguing that the move could make it more difficult for Microsoft to compete with Google and Yahoo.
In Ballmer's memo to Microsoft staff, he said that Microsoft's failed pursuit of Yahoo "was a tactic, not a strategy" adding that "we will get there with or without Yahoo."
He went on: "We continue to compete with Google on two fronts - in the enterprise, where we lead, and in search, where we trail. In search, our technology has come a long way in a very short time and it's an area where we'll continue to invest to be a market leader. Why? Because search is the key to unlocking the enormous market opportunities in advertising, and it is an area that is ripe for innovation.
"In the coming years, we'll make progress against Google in search first by upping the ante in R&D through organic innovation and strategic acquisitions. Second, we will out-innovate Google in key areas - we're already seeing this in our maps and news search.
"Third," concluded Ballmer," we are going to reinvent the search category through user experience and business model innovation. We'll introduce new approaches that move beyond a white page with 10 blue links to provide customers with a customized view of their world. This is a long-term battle for our company and it's one we'll continue to fight with persistence and tenacity."
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