Google Inc threatened to quit China, the world's biggest Internet market, warning it would no longer tolerate strict censorship of its Google.cn search engine.

The threat by the world's leading Internet search provider may win it praise for seemingly putting ethics above business, but give Microsoft and a handful of local rivals an edge in the huge yet problematic Chinese Internet market.

Google generated 53 percent of its $5.9 billion in third-quarter revenue outside the United States, although it does not disclose the size of its business in China.

While Google's potential exit from a Chinese search market that is growing at 40 percent would have little impact on its short-term revenues, analysts said that cutting itself out of this important market may carry a longer-term strategic cost.

Google issued its warning after discovering what it called a sophisticated and targeted cyber attack on its email service. Google said it believed hackers were targeting Chinese human rights activists.

That attack follows years of frustration in China for Google, which was heavily criticized for self-censorship when it entered the market in 2006.

China has more than 350 million Web surfers and annual search revenue topping $1 billion, but its Internet market has been a thorny one, with companies having to adhere to strict self-censorship rules dictated by Beijing.

Anyone disobeying those rules, which prohibit sites on sensitive issues like Tibetan independence or the outlawed Falun Gong spiritual movement, can have their site blocked or closed.

Google's move is related to censorship and not a business decision at all, said a high-level industry executive close to Google's former China chief, Lee Kai Fu, speaking on condition of anonymity because of the subject's extreme sensitivity.

Google has been agonizing for a very long over this decision. Since last year, Google was talking about making a gesture to show the Chinese government it will no longer tolerate strict censorship over its operations, the source said.

In a statement, Google's chief legal officer David Drummond said the cyber attacks and other attempts to limit free speech on the Web had prompted the company to review its China business.

We have decided we are no longer willing to continue censoring our results on Google.cn, and so over the next few weeks we will be discussing with the Chinese government the basis on which we could operate an unfiltered search engine within the law, if at all, Drummond said.

LEAVING A HOLE

China is one of the few markets where Google is not a leader, lagging Baidu, which has a 60 percent share of the Chinese Internet search market versus Google's 30 percent.

Other homegrown Chinese Web firms that also practice self censorship include Web portal operators Sina and Sohu, two of the country's best known Internet names.

Microsoft recently launched a Chinese version of its highly hyped Bing search engine in China, and said it is taking the market very seriously. Microsoft, whose rival Hotmail e-mail service is also available in China, said it had no indication that any of its mail properties had been compromised in China.

A Google exit from China could open up the field for others, including Microsoft, and allow Baidu to increase its dominance.

We believe there's a high chance that Google.cn will not be allowed to operate without censoring search results, JPMorgan analyst Dick Wei wrote in a note, adding Baidu would be a major beneficiary as it offers many of the same services as Google.

If Google.cn is not allowed to run in China, this could also benefit up-and-coming search engines like Tencent's SoSo, Sohu's Sogou and NetEase's Youdao.

Shares of Google fell 1.3 percent in after-hours trading on Tuesday, while Baidu jumped 6.8 percent.

MOVE UNLIKELY?

While some reckon Google could ultimately leave China rather than continue to censor itself there, other observers saw the company's announcement as a strategic move as it braces for tough negotiations with China.

My feeling is that it is more a comment than an announcement,' said Credit Suisse analyst Wallace Cheung. It seems like a statement before meeting with China's government.

Others also doubted Google would pull out of China.

We believe Google will probably stay as China is a vital market, said CLSA analyst Elinor Leung in a research note. Any China Internet veteran understands the need to work within the system and the Chinese preference for gradual change.

Many of Google's primary services, such as Gmail and Google.com, became briefly inaccessible to many Chinese users last year, and its YouTube video site has been inaccessible there since March.

(Additional reporting by Doug Young in HONG KONG, Edwin Chan in LOS ANGELES and Jim Finkle in BOSTON; Editing by Ian Geoghegan)

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